A 401(k) typically includes a number of different bond fund options. Bonds are debt instruments, and a bond fund normally contains thousands of instruments issued by different entities. Bond funds are typically less volatile than stock-heavy funds due to the relative price stability of the underlying investments. As with any kind of investment, your returns are based in part on your risk tolerance and the type of funds you purchase.
A mutual fund is an investment company that creates a pool of investments, including bonds. A 401(k) may contain both open-end and closed-end bond mutual funds. You can buy and redeem shares in the former at any time. The latter have an initial public offering and thereafter you can buy and sell shares on the stock market. Some mutual funds assess a sales charge while others are no-load funds. Mutual funds are actively managed by a fund manager, and management fees add to your cost. To reduce your costs, you can buy an electronically traded fund that tracks a bond index. EFTs are not actively managed: The related index dictates the make-up of the fund.
If you hold a bond to maturity, you get a return of premium. You can sell a bond mid-term, in which case it may sell for a premium or at a discount depending on the rates being paid on other readily available bonds. Short-term bonds -- those with terms of a year or less -- are subject to less price volatility than longer term bonds. Long-term bonds have terms of 10 years or longer and are the most volatile. Intermediate bonds fall somewhere between long-term and short-term bonds. Yields are generally higher on longer term bonds. You can select bond funds based on average duration. Your risk tolerance and investment time horizon should impact your selection.
Credit rating agencies grade bonds. The federal government is viewed as the lowest risk borrower, so Treasury bonds tend to pay the lowest interest rates. Bonds in major, long-established corporations pay higher rates, while rates on bonds issued by smaller firms are generally even higher. Bonds issued overseas expose you to losses caused by fluctuating currency prices. Yields of bonds issued by third-world nations and those issued by major economic powers vary greatly. Foreign bond funds provide a measure of protection in the event of a U.S. economic downturn. Some bond funds also contain mortgage-backed securities. The creditworthiness of the issuer dictates your return. As always, high rates are synonymous with higher levels of risk.
In the normal course of events, bonds are regarded as income-generating investments. However, you cannot actively withdraw money from a 401(k) until you leave your job or retire. Therefore, you can elect to have bond fund dividends reinvested in more shares or you can direct your 401(k) custodian to use the cash to buy other securities within the plan. You eventually pay ordinary income tax on your earnings when you make withdrawals. Since 401(k) income is fully taxable, it makes little sense to hold municipal bond funds in your account. Most munis generate tax-exempt income. If you held muni bond funds in your 401(k), you would end up paying income tax on that money .
Choosing the right bond fund for your 401(k) can prove time consuming due to the variety of considerations. Some plan custodians have made things easier by including unit investment trust funds within 401(k) plans. A UIT is an investment company that buys a pool of securities and liquidates the pool at a set date. You can buy a UIT bond fund that matures around the time of your expected retirement date.