Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 19)

Mutual Funds (part D)

by

Charles Lamson

Bond Funds

If you like bonds, you will love bond funds. This post concerns itself with bond mutual funds.

JUST A MINUTE Bond mutual funds offer the same advantages of diversification that stock mutual funds offer. By spreading the risks over a large number of issues, they reduce the risk and impact should a bond default.

The real killer for bonds and bond funds is the rise in interest rates. The longer a bond's maturity is, the more sensitive it is to interest fluctuations, and usually the deeper the discount.

Like all mutual funds, a bond fund offers the investor a chance to invest in bonds and spread the risk out over the collection of selected bonds. Bond funds are usually divided two ways: by the length of maturity of bonds they buy and by their tax status.

Short-Term Bond Funds

Short-term bond funds invest in bonds which mature in just a few years or less. Some argue that you are better off putting money into a short-term bond fund than a money market account or a bank certificate of deposit, because the yield will be better.

Usually people employ this strategy when they are saving for a purchase in the near future. The downside of this strategy is that spikes in interest rates will not only reduce your yield, but may cut into the principal value.

You may not earn as much with a bank CD, but your principal will be intact when you need it. The decision rests on how much risk you are willing to take.

Retired people in low-income tax brackets might favor such a short-term fund for its current income.

JUST A MINUTE Because bonds with longer terms are more risky, keep an eye on funds that invest in these issues for swings in price.

Mid-Term Bond Funds

Mid-term bond funds (5-10 years maturity) offer a great chance for higher returns than short-term bond funds, but have a corresponding higher risk of being hurt by rising interest rates.

Mid-term bond funds are more volatile and should be watched closely. Because of this volatility, it has become popular to trade in and out of bonds. Investors in bond funds should be careful that fees do not eat up any gain they hope to make.

Long-Term Bond Funds

Long-term bond funds invest in bonds with maturities out past 10 years as a rule and are the most volatile of all the bond funds. This volatility comes through exposure to interest rate fluctuations. The longer the term, the more chance rates will move up (or down).

Long-term bond funds are often put into retirement accounts to defer the current income created by the bond, where the owner is willing to chance the market fluctuations.

Tax-Free Bond Funds

One advantage bonds have over many other investments is the ability to offer tax-free income. Tax-free means exactly that, as opposed to tax-deferred. Bonds and bond funds do this by investing in city, state, federal, and special governmental agencies' bonds.

JUST A MINUTE High-income individuals find the triple-exempt bonds an attractive option. Triple exempt bonds are usually municipal bonds issued in states where there is an income tax and in communities that also have an income tax and in communities that also have an income tax.

Which tax the bond's income is free of depends on which bonds the fund buys:

• Income from treasury bonds and bills are free from state and local tax, but subject to federal income tax.
• Income from bonds that are issued by a state are free from federal income tax and free from state income tax if the holder resides in the state issuing the bond. Bond funds that seek this double exemption invest in bonds from one state only, so you may find a California bond fund, for instance. If you live in a city where there is an income tax, those bonds will likely be free from local, state, and federal tax.
• Tax-free income from a bond fund only makes sense for people in high-income tax brackets. Whether the state and/or city you live in has an income tax will drive your decision to purchase bond funds that are state-specific.

Average investors probably will do better in stock funds, either deferring taxes by putting them in retirement accounts or investing in tax-friendly funds (more about those in a later post).

Corporate Bond Funds

Bonds issued by corporations as opposed to governmental agencies are, obviously, not tax-free, but often pay a better return than their public-sector cousins. Bonds issued by highly regarded companies are considered relatively safe investments.

Bond funds that buy highly rated (more about ratings in a later post) bonds generate a steady stream of taxable income and are more appropriate for people in a low-income tax bracket or housed in a retirement fund.

*ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 146-148*

END

JUST A MINUTE

Bond mutual funds offer the same advantages of diversification that stock mutual funds offer. By spreading the risks over a large number of issues, they reduce the risk and impact should a bond default.

JUST A MINUTE

Because bonds with longer terms are more risky, keep an eye on funds that invest in these issues for swings in price.

JUST A MINUTE

High-income individuals find the triple-exempt bonds an attractive option. Triple exempt bonds are usually municipal bonds issued in states where there is an income tax and in communities that also have an income tax and in communities that also have an income tax.