However, bond mutual funds and their fixed income can be just as important a piece of any portfolio as equities. Although you can get more bang for your buck with stocks, bonds can help you level off the volatility of the stock market. If invested wisely, an investor can use bond funds to not only increase the cash flow of their portfolio, but also see some growth.

Bond Mutual Funds

So how do bond mutual funds work? Similar to stock funds; portfolio managers buy an assortment of bonds based on the objective of the fund and what is available in the market.

Most bond mutual funds pay off a monthly dividend. That dividend can be paid out to your brokerage account in cash or re-invested by buying more shares of that particular fund. Please be aware the even if you re-invest the dividends, they are taxable in non-IRA accounts.

Bond Fund Categories

Like stock funds, there are many different types of bond funds, and investors have the same ability to diversify. There are bond index funds, government bond funds, state specific bond funds, corporate, international, etc.

Bond funds can be based on the average length of maturity of the bonds in the portfolio (short-term, long-term, etc.), the average bond rating (AAA rated, junk bonds), or other specific objectives of the fund (strategic income, diversified portfolio, emerging market).

Bond Fund Analysis

When it comes to picking a bond mutual fund, an investor must go through the same type of due diligence they would for a stock fund.

• Does this fund fit my objective?
• Is it to aggressive or conservative for my liking?
• Does it invest in the types of bonds I want to own?
• What is the history of the fund, the manager and the company?

Rather than give you specific bond funds as a suggestion, I’m going to finish this article by discussing the two best bond managers in the business (in my opinion). Between the two of them, they have over 90 years experience in the bond market and have been successful year after year.

Bond Investor – Bill Gross

You may not know the name Bill Gross, but if you have a 401k or ever watch CNBC, you may be using his funds and have seen him on TV. Mr. Gross is the founder and managing director of PIMCO. He manages over $800 billion (yes, that’s a B) in fixed income assets.

His PIMCO Total Return Bond Fund is one of the most popular bond funds in 401k programs across the country. He has been named the Morningstar Fixed Income Manager of the Year three times and is a “go to” person for many different news publications and media outlets for his opinion on the bond markets.

Bond Investor – Dan Fuss

Dan Fuss is the Vice Chairman of Loomis Sayles & Company. He was named to the Fixed Income Analyst’s Hall of Fame in 2000 and is one of the most brilliant minds in the business today.

The equity side has Warren Buffett and the fixed income side has Dan Fuss. He has made a habit over the last 20 years of creating stock-like returns in his fixed income portfolios. In a previous life, when I was a financial advisor, every single portfolio I ever developed had his Loomis Sayles Strategic Income Fund in it.

Mr. Fuss is a much more aggressive investor than Bill Gross. I often used the two of them together almost as a yin and yang for bond portfolios. These men will bring a tremendous amount of knowledge and experience and proven to success to any portfolio. As always though, make sure the investments you choose fit your objectives, time tables and risk tolerance.     

Hopefully this look at bond investing will give some good food for thought as you plan out your portfolio.  For more on bonds, you can also read up on bond investing terms and some bond investing strategies.

Bond Ladders

Bond ladders are a strategy where an investor purchases bonds with different maturity dates. It is the fixed income equivalent of dollar cost averaging. Let’s say for example, an investor wants to spread out the maturities of their bonds, but keep an average weighted maturity of 5 years. They can purchase five bonds with maturities of 1, 3, 5, 7 & 9 years. As the bonds mature, the investor will continue to purchase bonds at the longer maturity.

This helps the investor manage interest rate risk. When interest rates are rising, they can purchase into those bonds with the higher yields. If the rates are dipping, the investor will still purchase the bond and take advantage of the yields of the current bonds they own.

The further the maturity the date, the riskier the investment can be. Most bonds are issued with a maturity date 30 years out. If an investor has a longer timeframe, they can push out the maturity dates of the ladder for a possible higher yield.

Bullet Bond Strategy

This strategy is great for an investor who has a specific target date. For example, a child will be attending college in 15 years. The investor does not need the principal of their investments until that time. Bonds of different varieties and lengths, but with maturity dates around the same time 14-15 years out, can be purchased and held until maturity. There is no interest rate risk because the funds are not being used to purchase new bonds.

Another way to do this, or combine with the bullet strategy is to purchase zero-coupon bonds. These are bonds that are sold at a deep discount, but do not pay any interest. An investor can purchase these bonds and hold them until maturity and take advantage of the discount they received.

Barbell Bond Strategy

With a barbell, the investor purchases bonds with a short-term maturity date and then others 20-30 years out. You create an average weighted maturity somewhere mid-term. In this case, the investor is hoping to take advantage of the inverse relationship of price and yield. If the yield of the longer term bonds drops, the price of the actual bond on the market will go up. The investor will then sell those bonds and realize the gain in principal. They use the shorter term bonds for the interest.

All investment strategies have risks, but this one can hit you on both ends. The yield of short term bonds can drop and long term bonds can rise. If this happens, the barbell strategy becomes a loser for this investor.

Bond Diversification

One final strategy is to treat your bond portfolio as you do your stocks. Think of the maturities and credit ratings of bonds the way you do market cap for stocks. You can purchase a mixture of bonds based on industries, maturities, credit rating and geographic location. We won’t go into the details here because this takes a bit more work, and is not for the novice investor. It can have a rewarding effect on your portfolio though.

As with any investment, each of these strategies comes with varying degrees of risk and different tax implications so make sure you consult a financial professional before making any decisions.

If you don’t know the bond investing basics jargon, you could easily get left behind, or worse, make a poor decision. Here’s a quick list of terms to help as you navigate investing in the bond market:

Accrued Interest – The interest that has been earned, but not paid out to the bondholder. Bond interest accrues equally every day and does not compound.

Call Date - Some bonds have a provision that give the issuer the ability to redeem the bond early. There is usually one call date per year. The list of dates is called the “call schedule.”

Call Premium – The payment by the bond issuer if the bond is called before the maturity date. This is the incentive that makes bond investors look at callable bonds compared to non-callable ones.

Coupon Payment – The actual dollar amount paid to the bondholders at each coupon date.

Coupon Rate – The annual interest rate paid to bondholders. Rates are generally fixed, though variable rate bonds are available.

Current Yield – The annual interest payment divided by the current market price of the bond.

Discount - This is when a bond is sold at a discount to its face value.

Face Value – Also called the principal or par value of the bond, this is the amount that will be repaid when the bond matures.

Maturity Date – The day in which the last interest payment is made, and the face value of the bond will be repaid.

Real Rate of Return - The combination of the interest earned and the market value of the bond.

Term to Maturity – The time left until the bond matures and the principal is repaid.

Yield to Call – This is the calculated yield from the current time until the call date. It is assumed that the bond will be called at the next call date.

Yield to Maturity – The compound average annual expected rate of return if the bond is purchased at its current market price and held to maturity. It is assumed in the calculation that the interest payments are reinvested for the life of the bond at the same yield. This is also called the internal rate of return of the bond.

Yield to Worst – This is a “worst case scenario” in terms of yield on a bond. It is the lowest yield possible for a bond.

This is certainly not an all-encompassing list, but I do hope it helps you the next time you hear investors talking about the bond market on television or if you’re looking up a bond quote yourself. For an intro to bonds you can check out the bond investing basics post; next time we’ll take a look at some bond investing strategies.

Bond investments should probably be a part of most portfolios; across all ages, investing goals, and levels of risk tolerance. The problem is many people spend their time learning how to invest in stocks and aren’t aware of the benefits that investing in bonds can offer.

In general, investors spend very little time investigating the opportunities in bonds, and because of this can leave money on the table. Over the course of the next few articles, I’m going to share some details on the different types of bonds, some bond investing terms, and finally some bond investing strategies that you can implement in your portfolio.

Bond Definition

Let’s start at the very beginning. A bond is a debt security. When an investor purchases a bond, they are lending money to the issuer of that bond. In return for the cash, the issuer gives you a document, or a “bond,” stating that they will return your money to you at a certain date, either the maturity of the bond or when it is “called.”

You will also receive a specific rate of interest for the life of that bond. Like stocks, most of them are traded electronically now, so you will not receive an actual “document,” but you will receive all of this other information.

Types of Bonds

There are many different types of bonds. They each have their own features and benefits. Which ones fit into your portfolio depend on what you are looking for.

Municipal Bonds – These are bonds that have been issued by states, counties, local municipalities and other government entities. They are used to finance the building of hospitals, highways, schools and other public projects that help that community. Many of these bonds offer both state and federal tax exempt income for residents of that state. For example, if you lived in Texas and purchased a San Antonio Hospital bond, the interest you earn from that bond will be tax-free. Not every bond offers this, so make sure you know what you are purchasing or consult a professional.

U.S. Treasury Securities – These encompass T-bills, T-bonds & T-notes. TIPS also fall under this category. These are securities issued by the U.S. Treasury and are backed by the “full faith and credit” of the U.S. government. These are considered to be the safest investment and have no “credit risk” in that the chances of not receiving your interest or principal back from the government are extremely small (trust me, if you don’t get paid, we all have a LOT more to worry about at that point).

Corporate Bonds – These are bonds that are issued by companies to help finance expansion other capital investment or cash flow. Investors have a much wider range of possibilities here, but also more risk. Whenever you invest in a bond, you always take on the chance that the company could go bankrupt or fold. It is important to know the credit rating of a specific bond and that company before you purchase the bond.

Mortgage-Backed/Asset-Backed Securities – When an investor purchases one of these, they receive a stake in pools of loans or other financial assets. As the loans, or other assets get paid off, the investor receives interest. These securities have come under considerable fire over the last two years. With the housing bubble and the implosion of several major financial companies, these types of investments were used too often, and in ways they were not made for.

These are the four major categories of bonds. Inside each of these are many more varieties of bonds and other debt securities. As always, make sure you do your due diligence when purchasing bonds. They have more moving parts than a stock. I’ll go over those moving parts in the next article on bond investing.