Bond Funds: The Frosting that Holds the Cake Together

Why bond funds are a key ingredient to a diversified portfolio

Hey there Money Saver! Welcome back to another week of How to Save A Buck, where we explore ways of saving money in personal finance, credit cards, and investing! Check out my archive here!

You make a double-layer cake and frost the exterior.

But the two cake loaves are unsteady when stacked. Frosting in the middle helps glue them together.

Bond funds are that middle layer of frosting. Investing in them is a smart way to balance your investment portfolio. Unlike equity funds, which invest in stocks, bond funds pool money from investors to purchase a variety of bonds.

We’ve always said diversification is key and helps dampen the risk of your overall portfolio. Why are bond funds important? What funds should I consider? Are they more expensive than equities? How much should I allocate?

Here’s what you need to know about bond funds and why they might be a good fit for your investment strategy - beyond your birthday cake.

The Bond Fund cake

What Are Bond Funds?

Bond mutual funds and bond ETFs are funds that invest primarily in bonds. They can include government bonds, municipal bonds, corporate bonds, and more. The main goal of bond funds is to provide regular income to investors through interest payments.

As you may recall, bonds are loans - you are loaning money to an entity that agrees to repay you the principal amount plus interest over time.

How Do Bond Funds Differ from Equity Funds? 

The key difference between bond funds and equity funds lies in their assets.

While equity funds invest in stocks, hoping for capital appreciation, bond funds focus on income stability and preservation of capital. Bonds typically have a lower risk profile compared to stocks, making bond funds a safer investment, notably during volatile market conditions.

Why Include Bond Funds in Your Portfolio?

Bond funds offer diversification, professional management, and liquidity. They pay out interest income regularly, usually monthly, and can be more accessible for small investors compared to buying individual bonds.

(Buying individual bonds can be expensive, as most are priced at $1,000 each with minimum purchase requirements. Buying them also requires a broker - they are not listed on an exchange like stocks or ETFs.)

Including bond funds in your portfolio can reduce overall portfolio risk. They act as a cushion against the volatility of the stock market, making them an essential component for a well-rounded investment strategy.

Popular Bond Funds and Their Details 

Some of the most popular and cheapest bond funds include:

  • Vanguard Total Bond Market Index Fund (VBTLX): With an expense ratio of just 0.05%, this fund offers broad exposure to U.S. investment-grade bonds.

  • PIMCO Total Return Fund (PTTRX): This fund has an expense ratio of 0.75% and aims to maximize income while maintaining capital preservation.

  • Fidelity U.S. Bond Index Fund (FXNAX): With an expense ratio of 0.025%, it’s one of the cheapest bond funds around. It’s designed to provide returns that correspond to the aggregate price and interest performance of the U.S. bond market.

(Some popular equity funds are similarly priced - anywhere between 0.03% and 0.10% expense ratios.)

Recall, an expense ratio is the cost of the fund per a dollar amount.

So, a 0.025% expense ratio means you’d pay $0.25 for every $1,000 invested (0.00025 x $1,000 = $0.25)

Now that’s cheap!

Disclaimer: I personally invest in VBLTX. Despite investing heavily in equities due to my risk profile, I invest in this bond fund for its diversification. It pays out a monthly dividend and I reinvest these back into the fund.

Previous 6 months of my personal investment in VBLTX

 

Tax Ramifications 

While I’m not a tax accountant, it’s generally accepted that municipal bond funds are often more suitable for taxable accounts because the interest they generate is usually exempt from federal income taxes, and sometimes state and local taxes.

On the other hand, taxable bond funds are better suited for tax-deferred accounts like IRAs or 401(k)s, where the taxes on interest income can be deferred until withdrawal - like the above example from my portfolio.

Risk/Reward Profiles 

Bond funds come with their own set of risks and rewards. Generally, the higher the potential return, the higher the risk. For example, high-yield bond funds offer higher interest rates but come with increased credit risk.

These higher-paying bonds have a higher chance of not being able to repay the bond.

Not all Bonds are Alike

While the above chart shows the performance of an equity ETF vs various bond ETFs, know that not all bond funds are alike. Bonds, like stocks, have varying degrees of risk with some being safer than others. Some funds invest in bonds that have different timeframes or durations.

For an average investor, a bond fund like the ones mentioned previously invest in hundreds, if not thousands of bonds. Exposure to a total bond fund that encompasses all these bonds is the goal - not stressing about the intracacies of each bond.

Remember, no investment is without risk, but bond funds can be a valuable part of your investment strategy, offering a balance between risk and reward. A general rule of thumb is subtract your age from 100 and that’s the percentage of bond funds that should be in your portfolio. But, this is just a general rule - not absolute.

Leave the risk-taking to baking a cake - and hoping it doesn’t topple over without extra frosting!

Save On,

Chris