Millions of people who don’t know how to invest in individual bonds invest in professionally managed bond funds instead to get higher interest income. Here’s what you need to know if you invest in these funds or plan to. The OBJECTIVE of bond funds is higher interest income with price stability (of the fund shares). That’s the objective, but it’s not a guarantee, because the price or value of a fund’s shares will change as the price of the bonds in its portfolio fluctuate as they trade in the bond market. If you don’t know how to invest to moderate your risk you could be setting yourself up for a significant loss of principal in the future. The same holds true if you invest in the wrong bond funds.
There are two primary ways to increase both your interest income and your risk at the same time in bond funds. First, you can invest in long-term funds that hold bonds that mature on average in 15 or more years. Since bond securities have a FIXED interest rate that never changes for the life of the investment (until maturity), long-term bonds become much less attractive as interest rates go up. As a result their price or value falls significantly in the market. The share price or value of bond funds holding these securities will follow suit. This is called INTEREST RATE RISK, which can be moderated by investing in intermediate-term bond funds that have average maturities in their portfolio of 5 to 10 years.
By going shorter-term, as above, you will sacrifice some interest income in exchange for less risk of heavy loss of principal when interest rates go up. Here’s how to invest to increase your interest (paid in the form of dividends) without taking on significant risk. Buy intermediate-term funds that hold medium to high quality bond issues vs. the highest quality (like U.S. Treasury securities). The real risk today is that interest rates will go up and sent bond prices crashing. Intermediate term funds have much less interest rate risk because the bonds held will mature and can be replaced sooner by higher yielding issues.