Bond Fund Pitfalls

Bond funds have been an attractive place for investment for risk-averse investors, who consider single bond investment as riskier. But, they fail to identify the hidden implications that bond funds carry with them. Some of the illusions connected with bond funds are:

• Fixed-income investments

  As implied in their name, many investors state that bond funds are fixed-income investments that guarantee you certain amounts of money after particular period. Such investors miss the important point that bond funds' yield is not fixed, but instead fluctuates. Additionally, the fund is not contractually obliged pay investors back their principal at a predetermined maturity date.
• Constant risk-return profile

  This misleading belief is refuted by the fact that fund managers constantly trade their positions. This means that the risk exposure is under the control of the manager, contrasted with the actual bonds where the risk level decreases with the increase in the time during which the investor holds the individual bonds.

On the other hand, this does not mean that you should not invest in this king of funds. You should carefully consider exactly what outcome you want to achieve by putting your money in bond funds. Additionally, you should consider:

1. Size of investment

   You should have in mind the amount you are willing and able to invest when deciding on embarking on bond fund investment. Putting your money in a municipal-bond fund will be suitable if you have up to $100 000 and you want to get a tax-exempt income. The amounts you need to invest in some municipal bonds are:

   • Vanguard - a minimum of $3000
   • American Century's Benham funds - $2,500 or $5,000 (depending on the fund)
   • Scudder - a minimum of $2,500
2. Types of bonds

   If you are interested in investing in corporate bonds, you should consider participation in a bond fund, since corporate bonds require an immense stake. Bond funds eliminate such burdens as high transaction costs, tax implications and the possibility of being deprived of the best ones by the issuer. The latter will result in a halt in your income inflow.

   Aside from corporate bonds, government mortgage bonds also represent difficult deals. Nevertheless, the participation in a fund is not recommendable, due to the high cost that accompanies such an investment. This high cost significantly outweighs the higher yields that mortgage funds offer.

3. Incur cost for the convenience

   When analyzing the possibility of buying a bond fund, the investor should carefully consider whether s/he is willing to buy convenience by paying the high price of long-term risk and high cost. It is true that bond funds yield returns on monthly basis and thus facilitate cash management, but is it worth the long-term risk and added cost?

Many investors prefer bond funds over directly buying bonds due to the benefits they offer. But you should always consider the other side of the coin in order not to end up giving up something more worth owning.  

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