Characteristics of Bond Funds Knowing the primary features of a bond fund may help when it comes to choosing a fund that is right for you. For example, how will the maturity and quality of a bond portfolio affect the amount of risk in a fund? Or how can you compare the income potential of different funds?
Interest RateIn the same way you pay interest on a loan to a bank, companies that issue bonds pay interest to their investors for the use of their money. On most individual bonds, this is a fixed percentage of the face value of the bond paid regularly over a fixed period of time. Because this is generally a fixed percentage, the value of a bond can be sensitive to interest rate changes in the market as new bonds are issued at different rates.
When you invest in bond funds, it is more likely that this rate, or yield, will vary from day to day due to the price fluctuations of the bonds in the portfolio. This income, or yield, can help manage your portfolio's volatility and make a significant contribution to your investment returns.
MaturityEach individual bond has a specific date when the issuer is required to return the initial investment back to the investor. This is called the maturity date. Bond maturities are generally classified into three categories short-term, intermediate-term, and long-term. Bonds with maturities of one year or less are considered short-term, bonds with maturities between two and 10 years are considered intermediate-term, and bonds with maturities greater than 10 years are considered long-term. Bonds with longer maturities tend to be more volatile, because there is more time for interest rates in the market to affect the prices of the bonds.
Bond mutual funds do not have a set maturity date, due to the fact that there are generally several different issues within a portfolio, and there can be constant turnover in a fund. Instead, bond funds report an average maturity in order to give investors an idea of how much risk might be associated with the fund.
QualityTo help define the risk associated with different debt issues, rating agencies assign quality ratings to the bonds when they are initially issued. The agencies continuously monitor certain characteristics of the company and its environment to decide how well the issuer will be able to make the scheduled payments on its issues. Some of the more well-known rating agencies include Standard & Poor's, Moody's, Fitch IBCA, Duff & Phelps, and Thomson BankWatch.
Ratings can range from AAA (highest quality) to D (default). Bonds with ratings of BBB or higher are considered investment grade issues, and bonds with ratings of BB or lower are non-investment grade issues. Bonds in the non-investment grade category are more speculative and often referred to as "high-yield". This is due to the fact that lower rated bonds generally carry a higher interest rate to compensate the buyer for taking on additional risk.
Ratings of Debt Obligations