Bond Fund: Introduction, Investments, Trading, Example & Risks of Bond Funds

So now that we have seen the fallback and downturns of the stock markets, suddenly all the great traders and investors in the world have become cautious about the thing called RISK and SECURITY of their investments. It is human nature, when markets were going up and up and above in the last 6 years, everyone just hopped onto the stock market investments. Trouble started when the stock markets fell apart and people became concerned about risks, and they started seeking protection of their capital looking for alternatives to security and stock investments. Bonds or related financial products like Bond Funds provide an alternative to that in a compartive less risk less return formula.
In this article, we will discuss the concept of Bond Funds, How bond funds are traded, How to invest in Bond Funds, An example of Bond Fund and the risks associated with Bond Funds.

Let's begin with the basics:
What is a bond fund?
Like any other stock based mutual fund which invests in stocks, a bond fund is a sort of mutual fund which takes money from individual investors and invests it in the different bonds available in the market.

What are the kind of returns expected from a bond fund?
A bond gives interest at pre-defined intervals - like quarterly, six months, annual, etc. Since a bond fund invests in multiple types of bonds, it can pay dividends to its investors. But this is at the sole discretion of the bond fund manager and it is not his obligation. Though generally the bond funds tend to pay dividends more frequently than the individual bonds.
Other form of return that can come from bonds is the capital appreciation, i.e. instead of paying the dividend, the money is reinvested. Hence, if investors are looking for long term capital appreciation, then they can benefit from this.

What are the different types of bonds and bond funds available for investments?
There are mutliple types of bond funds depending primarily on the underlying bond type investments:

- Government or Treasury Bond funds: The bond funds which invests in bonds issued by Government or Treasury. Considered to be the most risk free investments as they are backed by the goverment.

- Mortgage Bond Funds: These bond funds are backed by the Mortgage loans issued. Their income or interest to be paid is derived from the interest on the mortgage loans. However, there is a risk of default on the mortgage loan and hence they are comparatively riskier than Goverment or treasury bonds. We have seen examples in recent past when even government backed mortgage companies like Freddie Mac & Fannie Mae were in problems.

- Municiple Bond Funds: Another safe investment. They are the bond funds which invest in bonds issued by the municple corporations. They sometimes also offer tax benefits.

- Corporate Bond Funds: These bond funds are the riskiest of the lot. For e.g. Effect on Lehman Brothers Bonds after Lehman Brothers Bankruptcy. Though rating agencies like S&P and Moody's tend to give a rating to these corporates and bonds, there is no guarantee of anything. It all works randomly and we have seen the fates of Lehman Brothers going bankrupt.

-Regional bond Funds: You can also have bond funds that invest in bonds of a particular region, like Russian Bond Funds, Asian Bond Funds, South America Bond Funds, etc.

What are the advantages of investing in Bond Funds
Firstly, they offer Diversification. A bond fund will not invest in bonds from one single company, but from multiple companies, hence it will be less risky compared to individual bond investments. On the flip side, it comes at the cost of fund management charges and administrative charges.

Related: Tax-Free Municipal Bonds & Tax Free Bond Fund ETF & Low Cost Mutual Funds

Liquidity: Another major benefit. You can sell back your bond fund units anytime you wish. Copare that to your individual bond investment, it will force you to wait for the bond to mature before you can redeem your money.
Then there are the implicit benefits of professional money management, but they come at a cost.

What are the risks of investing in bond funds?
First - the bond funds come at a cost - load, administrative charges, fund management charges or whatever they can be called.
Second - Corporate bonds are risky - no one knows the in and out of company issuing bonds. Any instance like Lehman Brothers bankruptcy can happen anytime
Third - They do not shield you from inflation