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With interest rates now offering better cash flow, bonds and bond funds have become more attractive. They can steady a volatile portfolio and provide regular income. Below is a clear look at what bonds are, how bond funds differ, and how to add fixed income to your investing mix.
Bonds are part of the fixed-income family. Unlike stocks, which represent ownership in a company, a bond is a loan to a company, government, or government agency. In return you receive periodic interest (called coupon) payments, and when the bond matures you get your original investment back.
The coupon rate depends on the bond’s length and the borrower’s credit quality. Longer-term bonds often pay more than short-term ones, and lower-credit (riskier) issuers usually offer higher rates than top-rated issuers. Bonds come in many forms: government (including Treasury bills, notes, bonds, I Bonds, and TIPS), agency, municipal, corporate, high-yield (junk), and zero-coupon bonds. Maturities range from very short (one month) to 30 years or more.
Some bonds have tax advantages. U.S. Treasury interest is generally exempt from state and local tax. Many municipal bonds are exempt from federal tax and may also be free from state and local tax if issued in your state.
How you earn from bonds
You can profit from bonds in two main ways:
– Interest income: Regular coupon payments provide steady cash flow. Individual bonds and many bond funds pay interest regularly—bond funds often pay monthly.
– Price gains: If market interest rates fall, existing bonds and bond funds can rise in value, letting you sell for a gain.
If you buy an individual bond at issue and hold it to maturity, your return is essentially fixed and predictable (barring default). Bond funds, by contrast, own many bonds and have no maturity date; their payments and value change as the fund buys and sells holdings.
Key yield measures
– Coupon rate: The stated annual interest on the bond’s face value. A $1,000 bond with a 4% coupon pays $40 a year.
– Current yield: Annual coupon divided by the bond’s current market price. If that $40 coupon bond trades at $1,100, the current yield is $40 / $1,100 = 3.64%.
– Yield to maturity (YTM): The total return you’d get if you buy the bond now and hold it to maturity, including coupon payments and any gain or loss at maturity. YTM assumes interest payments are reinvested at the coupon rate.
– Yield to worst: The lowest possible yield you could receive, accounting for features like call provisions or if you sell before maturity.
These ratios are usually shown on bond listings and in fund factsheets to help compare potential returns.
Bond funds versus individual bonds
Individual bonds have a fixed coupon and a set maturity date. Bond funds do not mature, and their income varies as holdings change. Funds also charge management fees—index bond funds tend to be cheaper than actively managed funds. Benefits of bond funds include instant diversification and professional management. Downsides include ongoing fees and the lack of a guaranteed return of principal at a specific date, since the fund continuously buys and sells bonds.
There are two main types of bond funds: exchange-traded funds (ETFs) and mutual funds. ETFs commonly have lower fees and trade like stocks, while mutual funds may be better for certain strategies available only through that structure.
Where to buy bonds and bond funds
Major brokerage firms offer access to individual bonds, bond mutual funds, and ETFs, and often provide tools and specialists to help choose fixed-income investments. You can buy U.S. government bonds directly at TreasuryDirect.gov. When choosing a broker or fund, compare fees, available inventory, and any commission costs.
Which approach makes sense
If you have a large sum (for example, $50,000 or more) and want to know exact cash flows and maturity payoffs, buying individual bonds can make sense. For most investors, bond ETFs or mutual funds offer better diversification, lower cost, and greater flexibility.
How bonds fit in a portfolio
Including fixed income typically reduces overall portfolio volatility and provides steady income. In tax-advantaged accounts like IRAs or 401(k)s, bond interest grows tax-deferred. If interest rates are expected to rise, shorter-duration bond funds can help protect principal because bond prices move opposite to interest rates.
Practical example
Imagine a five-year bond issued at $1,000 with a 4% coupon. It pays $40 per year, often in quarterly installments of $10. If you buy that bond on the open market for more or less than $1,000, your effective yield changes because the coupon stays $40 but you paid a different price. When the bond matures, you receive the face value (par) back, regardless of what you paid—unless the issuer defaults.
A note on recent yields
Returns vary with market rates and maturity. For example, in fall 2024, short-term bond funds were paying around 4.75% while long-term total bond funds were closer to 3.25%. Short-term funds tend to offer higher yields than cash but lower interest-rate sensitivity than long-term funds.
Bottom line
Bonds and bond funds provide steady income and help stabilize portfolios. Understand the different types, tax features, and yield measures before choosing between individual bonds and bond funds. For most investors, bond ETFs and mutual funds offer a simple, diversified, and cost-effective way to add fixed income to a portfolio.
