Extreme closeup of U.S. EE savings bonds fanned out over one another. Concept photograph for the United States national debt.

3 Things to Know About Bond Funds

Even bonds funds can have risk. Find out which funds are riskier than others.

Extreme closeup of U.S. EE savings bonds fanned out over one another. Concept photograph for the United States national debt.

There many types of bonds funds, from corporate bond funds to national long municipal bond funds.

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Interest rates are at or near record low levels. You get virtually nothing on your savings or certificates of deposit, interest rates on home mortgages are low, as are interest rates on bonds. Investing in bond mutual funds is a challenge for investors. Here are three things to know about your bond funds:

1. Think total return not just yield. The overall returns for a bond fund come from the yields on the underlying bonds held by the fund as well as gains and losses on the underlying bonds held by the fund. This includes both realized and unrealized gains. Although the longer-term return on a bond mutual fund should equate to its yield, other factors will come into play that can cause fluctuations in the value of the fund in the short term.

2. Duration is key to your fund’s sensitivity to interest rate fluctuations. Morningstar's definition of duration is, “a time measure of a bond’s interest-rate sensitivity, based on the weighted average of the time periods over which a bond’s cash flows accrue to the bondholder.” A bond’s cash flows include the value received at maturity, generally $1,000 per bond, and the periodic interest payments received by the holder of the bond. A bond’s duration is expressed in years and is generally shorter than its maturity.

For example, PIMCO Total Return, the largest bond mutual fund has a duration of 5.37 years as of Dec. 31, 2013, according to Morningstar. This means that everything else being equal a 1 percent increase in interest rates would result in a 5.37 percent decline in the value of the fund’s underlying holdings. In reality, duration is a guide and other factors such as the fund’s yield would factor into the impact on the fund’s total return.

As a comparison, the Vanguard Long-Term Bond Index has a duration of 14.2 years, indicating a 14.2 percent decline in the portfolio, if interest rates were to increase by 1 percent.

3. Bond funds come in many styles. Make sure that you understand how your fund invests your money.  There are numerous categories for bond funds including:

  • corporate bond
  • short-term bond
  • short-term government
  • ultra-short bond
  • intermediate bond
  • high-yield municipal bond
  • inflation-protected bond
  • world bond
  • nontraditional bond
  • long government bond
  • long-term bond
  • multisector bond
  • national short municipal bond
  • national intermediate municipal bond
  • national long municipal bond
  • various state specific municipal bond funds

Besides duration, the funds across these categories can exhibit very different behaviors. For example, high-yield bond funds (aka junk bonds) invest in below investment-grade bonds that typically have a higher yield than investment-grade bonds and bond funds. These funds tend to behave more like stocks than bonds and have less sensitivity to interest rate fluctuations than other bond funds.

World bond funds contain varying percentages of foreign bonds, which, besides interest rate and credit risk, can expose the fund holder to currency fluctuation risk, unless the fund hedges its currency bets.

PIMCO Total Return is a core intermediate bond fund, yet at times it will have short positions to try to enhance returns. Unconstrained bond funds are what they sound like, bond funds that can invest almost anywhere on the fixed-income spectrum. Even tame sounding ultra-short bond funds can be fraught with risk, as evidenced by the recent lawsuit settlement by Charles Schwab over one of its ultra-short bond funds. The suit centered on their YieldPlus fund that lost 35 percent during 2008 and alleged that Schwab misled investors about the risks associated with the fund.

The point here is that like any other investment, you need to understand how your bond fund invests your money. You also need to understand the risks associated with the fund. And most of all, you need to understand how your bond funds fit into your overall portfolio and what you are looking for those funds to accomplish.

With interest rates dropping for much of the past 30 years, investing in bond funds has been pretty easy. With interest rates at record low levels, meaningful returns in fixed-income may be hard to come by over the next few years.