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Introduction to Mutual Funds – Types Of Bond Mutual Funds

In the previous article we had seen about stock (equity) mutual funds in detail. In this article, lets continue from there and explore the various types of bond mutual funds.

Bond mutual funds invest in a type of fixed income securities called bonds. Investing in bonds is generally considered less riskier than investing in stocks as they are less volatile and provide regular income in the form of interest payments. Hence bond mutual funds are quite popular among the risk averse investors. (Individuals who don’t like to take too much risk). Bond funds constituted about 25% of the total mutual fund assets in the US in 2011 (year end) thereby being the second most preferred type of mutual funds after equity mutual funds. [1]

In this article, lets see about the various types of bond mutual funds. Continuing with our previous tradition we will do so by asking a few questions.

Question 1

Does the bond fund invest in domestic bonds or does it invest in bonds of foreign companies?

Depending on which we have
1) Domestic bond mutual funds
2) Global/World bond mutual funds

As their names suggest, domestic mutual funds invest in bonds which are issued in the same country while global bond funds invest in bonds issued in various countries.

Question 2

Does the bond fund invest in high risk speculative bonds or high quality investment bonds?

Depending on which we have
1) Speculative grade or Junk Bond funds (High-yield bond funds)
2) Investment grade Bond funds.

Junk bonds are basically speculative in nature and are considered high risk. In return, the bonds give a higher yield (interest) on the principal (amount invested). In contrast to junk bonds are investment grade bonds. They are considered safe to invest in but give a lower rate of return than speculative junk bonds.

As a good rule of thumb one must always remember that the yield of a bond is proportional to the riskiness of that bond. In other words, the more risky the bond is perceived to be, the more its yield (interest) will be.

Credit Rating

This activity of rating the credit worthiness of a corporation (or even a country) is done by certain agencies called credit rating agencies. Some of the familiar agency names often heard in the news include S&P, Moody & Fitch. These agencies take many factors into consideration and rate a particular security a grade.

Fitch (long term) rating scale is similar to S&P.

These rating agencies make it easier for investors to classify a given bond of a company or a country as either investment grade or speculative grade.

Question 3

Is the bond mutual fund investing in bonds issued by the government or is it investing in corporate bonds?

Depending on which we have
1) Government bond funds
2) Corporate bond funds
3) Muncipal bond funds

Government bonds (called the treasury bills in the US) are issued by the government in the local currency and are generally considered risk free bonds. Municipal bonds are similar to government bonds but are issued by the local state/city.

Why are government bonds considered risk free in nature?

The answer is pretty simple. Its hard to imagine a country defaulting on its debt obligations as it can raise taxes, cut expenditure (austerity) or simply print its way out of a default. (though that would be inflationary).

Nevertheless, credit rating agencies don’t consider all government bonds to be equally credit worthy and risk free. For example, Greek government bonds were recently cut to “selective default” (that is a grade within the junk bonds) by S&P due to the ongoing economic crisis in that country. In contrast, UK still holds its AAA rating (which basically means its bonds are among the safest and risk free investments out there).

In contrast to government bonds (as in treasury bills) are municipal bonds which are basically issued by the local/state municipality. They are used to fund projects such as bridges, roads and other public undertakings. The key difference one need to know is that while treasury bills are taxed, municipal bonds are tax free in most nations including the USA and India.

Corporate bonds, unlike government bonds, are not backed by the sovereign and hence are considered more risky.  However, there may be AAA rated corporate bonds issued by companies in a country whose bonds are AA rated.

For example, the US treasury bonds were recently cut a notch by S&P and are currently AA rated but quite a few companies based in the US such as Exxon Mobil, Microsoft, Johnson & Johnson still retain their AAA status making their bonds more safer than the US treasury bills.

To sum it up, we have seen that mutual funds might invest in bonds which are either of domestic or of foreign origin. The bonds could be of different grades ranging from high risk speculative ones to low risk investment grade bonds. They could either be issued by countries or corporations or even municipalities. Now that we have understood quite a bit about bond funds lets learn a bit about money market funds in the next article.

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Image credit – Jo@net

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