A bond fund is a mutual fund that collects money from investors and uses those funds to buy corporate or government bonds. Bond funds differ from money market funds in that bond fund managers tend to pursue strategies aimed at producing higher yields, and bond funds may purchase riskier low-quality or long-term bonds. Bond funds let investors gain exposure to many different bonds by purchasing a single investment, but they also present several investment risks and other disadvantages.
More Investment Risks
Bond funds present investment risks that may cause the value or shares to go down. First, bond funds are subject to credit risk, which is the possibility that a bond issuer fails to pay its debts. If a bond issuer doesn't pay, the fund could lose money and share values could drop.
Second, bond prices tend to go down when interest rates rise, so increasing interest rates can result in losses. Bond issuers may also choose to pay off bonds early if interest rates fall, which can reduce returns.
Bond funds are also susceptible to inflation risk. When inflation rises, the purchase power of your income is reduced. If you had intentions on living off of your bond fund income in your golden years, you need to take inflation into account as well.
Lower Return on Investment
Bond funds may invest in high-yield bonds to increase returns for investors, but returns on stocks have historically outperformed those on bonds. According to the financial website TheStreet, stock investments have outperformed other types of investments over the long term, including corporate bonds, government bonds and treasury securities. Stock funds – mutual funds that invest primary in corporate stock – may produce higher returns than bond funds.
Bond Fund Expenses
Bond funds have to pay various operating expenses, such costs related to marketing and selling fund shares, providing shareholders with services and paying managers. Mutual funds impose an annual fee called an expense ratio to cover these expenses.
Expenses reduce the effective return investors gain on their investments as these fund expenses can add up. For instance, if a bond fund's assets increase in value by 5 percent during the year but it has an expense ratio of 0.5 percent, the actual return for investors is only 4.5 percent. An investor who purchases bonds directly from an issuer does not face these costs.
Minimum Mutual Fund Investments
Mutual funds typically require a minimum investment to purchase shares that varies depending upon the investment firm. Fund minimums may be as low as $1,000 or even less, but many funds require minimum investments of $10,000 or more.
Mutual fund companies may even offer funds to companies and organizations that require minimum investments over $1 million. Funds with high minimums may offer lower expense ratios and other benefits, giving an advantage to wealthy and large institutional investors.