Bond Funds: What Are They, How Does It Work

Bond Funds are basically a collective investment that invests in actual bonds and other debt securities. Bond Funds will pay periodic dividends that may include interest payments on the funds securities plus they can also pay on period capital appreciation. When it comes to Bond Funds there is much information out there that it can become confusing and frustrating. Bond Funds like any other bonds run a high risk if you are not careful. When doing research you will want to find out as much as you can on the companies that are offering the bonds. You don't want to place all of your money in one company either. Bond Funds are a risk as well as any other type of bond.

When you buy a Bond Fund you have many different types of risk, you have everything from Interest Rates, Credit, Markets, Liquidity, Foreign Investors and Management Risk. You have to go in understanding that the company selling you the bond has hundred or maybe thousands of other people investing in the same thing that you are. When it comes to Interest Rates there is always a risk involved. Bond Funds dependent on any changes that may occur in the general interest rates and when the interest rates increase the value of the bond decreases. To fully understand interest rate risk you should know what duration means.

Duration means that it is a unit of measure of the bond fund's sensitivity to the changes of the interest rate. The higher the duration is the more sensitive the fund becomes. For example, let's say that the duration is a 4.0 and there is a 1% rise in interest rates this will cause the value of the bond to decrease by 4%. There is what is known in the world of finance as an alternative to the duration and this is called WAM or Weighted Average Maturity. This means that the weighted average time to mature the bond on the portfolio is years. The longer the WAM is the more sensitive your portfolio will be to interest rates. Though experts say that duration is more successful than WAM but this is something as a potential investor that you need to think about.

There are also Credit Risks involved, the amount of the US Treasury and the mortgage backed securities in the Lehman Aggregate Bon Index most bond funds are compared against the Index and should have a high credit rating of AAA, if it doesn't you are taking a bigger risk with someone with not as a good credit rating.

Lastly, when it comes to Bond Funds, they will most likely to give very little or no indication of what their future returns will be and this means that you will have no way of knowing if your investment is going to pay off. There are many things that you need to learn when it comes to different bonds especially bond funds. Talk to local bond brokers and see what they can offer you in terms on a risk and rewards. Remember that you are buying bonds to make money not lose money.