While bond funds can play a role in a well-balanced investment portfolio, these funds have their risks as well. Before you invest any money in a bond fund, it is important to first understand the potential disadvantages of those investments. From low yields and high costs to the potential for loss, bond funds have a number of risks you might not be aware of.
When it comes to bonds and bond funds, the rate of return and the level of risk go hand in hand. The higher the yield on your bond fund, the greater the risk, and vice versa. If you need to keep your money perfectly safe, you can invest in U.S. Treasury bonds, but the interest rate you receive will be quite low. In many cases you could get a better rate of return, and absolute safety, by investing in a certificate of deposit from your local bank. You can seek out a higher rate by looking to so-called high-yield bond funds, but the bonds these funds contain can be just as volatile and risky as stocks. High-yield bonds are also known as junk bonds, so named because the companies involved have poor credit ratings and, therefore, a higher risk of default.
Risk of Loss
Many people assume that bonds are safer than stocks, but that is not always the case. A bond fund is only as good as the bonds it holds, and in the case of corporate bonds, those bonds are only as solid as the companies that issued them. In addition, bond fund investors face risks that individual bond holders do not. When interest rates rise, the net asset value of the bond fund falls, and you could lose money if you have to sell. If you buy an individual bond and hold it to maturity, you get all your money back, plus the interest you earned along the way. There is, of course, a risk of default in individual bonds as well as bond funds, but you can mitigate that risk by choosing quality instruments.
Interest Rate Risk
Bond funds are subject to interest rate risk, and that risk can be quite significant, especially in a low interest rate environment. When interest rates are at historic lows, they have nowhere to go but up. When rates do spike up, the net asset value of the bond fund can decline significantly. You can mitigate this risk somewhat by choosing bond funds with an average duration of just a few years, but you still have some risk even with a short duration fund. You have this interest rate risk in individual bonds as well, but it only applies if you need to sell the bond early. While the value of your bond goes down when interest rates rise, you are not affected if you hold the bond to maturity and continue to collect the interest payments.
Keeping your mutual fund costs under control is always important, but it can be even more critical when investing in a bond fund. When interest rates are low, even a small expense ratio can really eat into your return and make a bond fund a bad investment. Just consider that if your bond fund has a yield of 2 percent and an expense ratio of 0.50 percent, that leaves you with a measly return of 1.5 percent. If you do plan to make bond funds a part of your portfolio, it is essential to choose the lowest cost fund you can find.
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