Bond funds provide interest income from the underlying investments in the fund’s portfolio. While you’re investing in your 401(k), that income is reinvested to buy additional shares. Allocating a portion of your 401(k) contribution to these fixed income investments can play an important role in creating a diversified portfolio, reducing investment risk and helping you achieve your long-term goals.
You can differentiate bond funds from each other in two ways: by the types of bonds a fund owns and by the average term of the bonds in the fund.
Generally, 401(k) plans offer five categories of bond funds:
- US Treasury bond funds, which invest in bills, notes or bonds issued by the federal government
- Agency bond funds, which invest in bonds backed by a pool of mortgages and issued by either agencies of the federal government or government-sponsored enterprises
- Municipal bond funds, which invest in tax-exempt bonds issued by cities and states in order to fund public projects
- US corporate bond funds, which invest in bonds issued by US companies
- International bond funds, which invest in bonds issued by corporations based overseas or by governments other than the US
The average maturities of the bonds in a fund may be grouped as:
- Short term, with an average maturity of one year or less
- Intermediate term, with an average maturity of 2 to 10 years
- Long term, with an average maturity of 10 years or longer
The longer a bond fund’s average maturity, the more sensitive it is to changes in interest rates. As rates go up, the net asset value (NAV) of the fund drops. And as rates drop, the NAV increases.
From an investment perspective, what matters most is a bond fund’s total return. That’s the interest the underlying bonds pay, which is reinvested to buy more shares, plus any increase or decrease in the value of your principal. The greater the total return, the better your investment is doing.
A long-term bond fund has greater potential than a short-term bond fund to generate high total returns when rates are falling, but its total return is more likely to decline when rates are rising. The most volatile bond funds, called high-yield funds, invest in low-rated bonds with the greatest risk of default.
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