Bond mutual funds typically pay monthly dividends, which investors must report on their taxes as income. Most other investments only pay on a quarterly, semi-annual or annual basis, so bond mutual funds are popular with people aiming to supplement their monthly income. The dividends paid by bond funds, like all dividends, are subject to change, so investors should not expect income levels to remain steady over the long term.
Bonds are a form of debt and bondholders are creditors who receive interest payments from bond issuers. Companies and governments sell bonds to raise money for capital projects and to cover short-term operating costs. Investment firms sell bonds tied to mortgages. Monthly mortgage payments that homeowners pay are received by investors as bond interest payments. Bonds are rated by credit rating agencies, and bonds issued by major corporations and nations pay lower yields because credit agencies view those companies and nations as low-risk borrowers. Small companies and developing nations are viewed as high-risk borrowers and therefore pay higher interest rates on bonds. These interest payments directly impact dividend payments from bond funds.
Government bonds typically pay interest twice annually, other types of bonds pay interest more regularly. Interest payments are received by the mutual fund company that manages the bond fund and passed on to shareholders monthly. Since bond funds contain thousands of bonds issued at different times, interest payments are received throughout the year. Fund managers determine how much to pay shareholders in the form of a dividend by estimating the total interest the bonds should generate over the course of the year.
Dividend payments on bond funds are paid on a per-share basis rather than on a dollar basis. If a fund paid a dividend of $0.50 per share, a bondholder who bought 1,000 shares in the fund at $20 per share would receive $500 in dividend income. Another investor who earlier spent $40 a share to buy 1,000 shares in the same fund would receive the same amount of dividend income despite having spent twice as much to buy the shares.
Municipal Bond Funds
The Internal Revenue Service does not require investors who own most types of municipal bonds to pay taxes on bond interest payments. Likewise, shareholders of mutual funds containing municipal bonds typically do not have to pay interest on fund dividends. However, shareholders do have to pay capital gains tax if they sell shares for a price in excess of the original purchase price. Taxes are due on both capital gains and dividends tied to other types of bond mutual funds.