Bond funds can be even trickier than bonds themselves because -- unlike the implication in their name -- they are not really fixed-income investments. Even when a mutual fund's portfolio is composed entirely of bonds, the fund itself has neither a fixed yield nor a contractual obligation to give investors back their principal at some later maturity date -- the two key fixed characteristics of individual bonds.
In addition, because fund managers constantly trade their positions, the risk-return profile of a bond-fund investment is continually changing: Unlike an actual bond, whose risk level declines the longer it is held by an investor, a fund can increase or decrease its risk exposure at the whim of the manager. In this way a bond fund is closer in character to equities than it is to individual bonds.
Does that mean that fixed-income investors should avoid bond funds? Not necessarily. Bond funds may be appropriate for investors who know exactly why they are going into these funds and what they expect to get out of them. That's why, before investing in a fund, it makes sense to ask yourself the following questions:
How much do I have to invest?
If you have less than $100,000 at your disposal, and you're looking to earn tax-free income, then your best choice is probably a municipal-bond fund. That's because a diversified portfolio of individual munis requires a commitment of at least $100,000. (Most munis are sold in lots of $25,000.)
What kinds of bonds am I interested in?
If the answer is corporate bonds, then, again, your best option is probably to choose a bond fund. Corporate bonds usually require a hefty stake -- and carry other burdens for the average investor: ample transaction costs, no shelter from taxes and the risk that the best ones will be called by the issuer, ending your income stream.
(Government mortgage bonds are also difficult to buy on your own, but here we don't recommend a fund. As many investors have learned the hard way, mortgage funds may offer somewhat higher yields than Treasurys, but that extra income can come at a brutal cost down the road.)
Am I willing to pay a price for convenience?
Some income-oriented investors have been enticed into funds because they simplify things: Many funds pay out yields monthly, rather than annually or semiannually, making cash management a far easier affair. Making a trade-off for convenience' sake is up to each individual, but we think that, in the long run, for most investors it's worth neither the added risk of bond funds nor the added cost.