How Do Bond Funds Work?

Mutual fund structure

Bond funds are mutual funds that buy bonds and other debt instruments. There are two main types of mutual funds; open-end and closed-end. Most bond funds are open-end funds which are less volatile than closed-end funds. Each time an investor adds money to the fund new shares of the fund are issued, these funds are not traded between investors.

Some bond funds are actively managed while others are index funds. Index funds buy a specific type of bonds, say all corporate bonds issued in the United States. Actively managed funds have a fund manager that uses investment expertise to pick specific bonds in the hopes of out performing bond indexes.

Investors buy bond funds to achieve relatively stable earnings which average 6-8% over long holding periods. To achieve these returns bond funds purchase bonds and use the coupon and maturity payments to return gains to the funds investors.

Types of Bond Funds

There are four main types of bond funds: international, core, short-term, and municipal. International funds invest most of their money in bonds outside of the united states. Core bond funds invest in only investment grade bonds and are fairly conservative investments. Short-term bond funds are very conservative and earn lower yields that core or international funds. Municipal bond funds only buy bonds from U.S. states and municipalities. Because these bonds pay tax free interest the bond funds earnings are tax free as well.


All mutual funds have three types of fees: loads, annual asset management fees, and 12b-1 fees. Loads are also called sales charges and are used to compensate advisors and brokers for selling the fund. Some loads are charged up front (A shares), some upon fund redemption (B shares) and others are ongoing (C shares).

Asset management fees are the fees the fund charges to operate the fund each year. Index funds have lower asset management fees than actively traded funds do. This fee can range from.10% to 2% and covers all internal costs to the fund including staff compensation, company management, and legal costs.

12b-1 fees are used as ongoing compensation for the financial advisor selling the bond fund. Index funds do not typically charge this fee.