Bond funds are mutual funds that help invest your money in a suite of carefully selected bonds. In 1929, the first fund accommodating bonds was created by Vanguard-Wellington. To get a full grasp of this type of mutual fund, you’ll need to understand how bonds work. So, let’s jump into that right away. If you’d like to skip that, tap any of the options below to jump right into any section:
- How bonds work
- What are mutual funds?
- Breakdown of bond funds
- How to pick the right bond fund
- Investing with bond funds vs Investing in individual bonds
- How to invest with bond funds
- Pros and cons of bond funds
What are bonds?
Bonds are simply agreements to pay back a certain amount over a period after a loan has been raised. For example, the government can decide to raise $2 billion via a bond with a minimum buy-in of $10,000. Hence, anyone who commits to lend the government $10,000 or more they are assured by the bond of periodic interest payments.
Taking a long throwback, we can see that bonds have been around for a really long time. The first existence of a bond has been traced back to 2,400 B.C in Mesopotamia. In the 1100s, the people of Venice followed suit and used bonds to fund their wars. However, it wasn’t until the 17th century before the first official government bond was issued.
From the above, we can deduce that bonds serve as a funding source for projects. At this point, it is important to note that even private entities can issue bonds. The principles are the same, all that changes is the issuer.
How do bonds earn returns?
There are two ways to make money from bonds. Either from the interest payments or selling your bond to another person at a higher price. For the first way, when a bond is issued an interest rate is attached. A simple example is a $1 million bond issued for 5 years at 10% per annum. Since most bonds pay out twice a year, you’ll receive 5% of the amount twice every year till maturity.
Upon maturity, your capital will be paid back. Throughout the entire period, the 10% promise will never change. However, it is possible to sell your bond before maturity and here’s where things get a little tricky. But we’ll use a simple example to get you in on the basics.
When you decide to sell a bond, you are making a secondary trade. Primary trade occurs when the bond is purchased directly from the source. Although the primary rate doesn’t change, the secondary rate does. Here’s what happens:
- A bond of $10,000 was issued at 6% per annum, for 5 years, and you purchased it. That is, every year you’ll earn $600 (6% of $10,000)
- One year later, you want to sell the bond, and various factors come into play–from inflation to general interest rates.
- Based on the factors mentioned above, your buyer is willing to pay $12,000. The secondary rate for this will now be 5%.
- Why? 5% of $12,000 retains the $600 promise in number 1 (5% of $12,000 is $600)
- In simple terms, as the price of a bond increases (in the secondary market) the rates drop and vice-versa. That way, we can always ensure the promised amount never changes.
The primary market refers to the first point of purchase. While the secondary market refers to reselling items after the first point of purchase.
What are mutual funds?
Now that bonds have been explained, let’s see how mutual funds work so as to get a clearer picture of funds that invest in bonds. A mutual fund is a pool of cash from various investors; which is then managed by a professional at a little fee. They make it possible for the average person to participate in investment opportunities that are not easily accessible.
>>Learn More: The first early appearance of a mutual fund was in 1774
Today, there are various types of mutual funds. But here are the five types you should know:
A breakdown of bond funds
As you might have realized, bond funds are mutual funds that invest in bonds. A fund manager selects a number of individual bonds, based on their experience, and spreads under their watch across the member bonds. You don’t have to worry about researching the bonds or battle the risks that come with holding individual bonds. Finally, bond funds are great for those who are comfortable with taking moderate risks.
How do you earn from bond funds?
To invest in a bond fund, you do so by purchasing units of the fund. And you gain as the price of each unit you own changes. For example:
If you buy 1000 units at ₦500 each, you have invested ₦500,000. If after a year, the unit price jumps to ₦550 you’ll have ₦550,000 (new unit price x number of units you own).
Now, you can choose to sell your units at any time to access returns earned, or you can wait for the fund manager to payout returns earned so far. Usually, if a fund is doing great, it is advised that you wait for payouts and reinvest them for compound returns.
A bond is issued by an entity in a country that isn’t theirs is known as a Eurobond.
How to pick the right bond fund
The answer to this is dependent on you. How much risk are you willing to take? Your choice is heavily dependent on your answer. If you are conservative, you’ll prefer bond funds that invest majorly in government bonds. And if you can handle some extra risk, you’ll be comfortable with bond funds that allocate more to corporate bonds.
To find out what a bond fund is, we have made it easier at Cowrywise. Each fund has an allocation display (as shown below) to state clearly where your money goes when put into a fund. In some cases, a bond fund can invest in other instruments asides from bonds.
Investing with bond funds vs. Investing in individual bonds
With a bond fund, you are exposed to various bonds with different maturity dates. The advantage here is that you have access to diversified investments and possibly better returns. On the other hand, with an individual bond, your exposure is limited.
Further, researching individual bonds takes time and intensive knowledge. With a bond fund, those two factors are taken care of by the fund manager. All you need do is give them your cash and they do all the heavy lifting while you wait for your returns.
Finally, accessing an individual bond can come at a really high cost. With bond funds, the cost is drastically reduced. For example, on Cowrywise it’s possible to invest in bond funds with any amount.
How to invest with bond funds
The usual path is to:
- search for fund managers,
- look through their funds,
- make a choice and deposit.
There’s another option, you get to access top bond funds in one space and start investing in 5 minutes—no long forms just a few clicks.
Pros and cons of bond funds
The big benefits of bond funds are these:
- They are not high-risk.
- They are cheaper to invest with than investing in individual bonds.
- Your invested cash with them is accessible at any time.
- Your investment is diversified with them.
On the other hand, here are the cons of this type of funds:
- They can lose money, as they’re not risk-free.
- You can earn lower interest rates/returns as fund managers tend to sell underlying bonds before maturity.
- You pay a management fee (though little).
Learn more about how mutual funds work.