Investing in bond mutual funds is a type of investment that has been gaining steam in recent years. The bond mutual fund involves bonds but is an alternative to directly investing in the bond market. Here are the basics of this type of investment and some information to clear up common misconceptions about it.

Bonds vs Bond Mutual Funds

Many investors get bonds and bond mutual funds confused. A bond is a debt instrument that is offered by an entity to investors. For example, corporations and the Federal government offer bonds to private investors as a way to raise money. They agree to pay a certain amount of money in interest over the life of the bond to the investors. Then at the end of the term, the investor gets the money that they invested back.

A bond mutual fund is a managed fund that does business by buying and selling bonds. When you invest in a bond mutual fund, you are actually buying shares into a portfolio of bonds. Therefore, you own a small piece of each bond that is owned by the fund. This is a more diversified way to invest in bonds as you own many more assets than if you were to individually buy bonds.

Losing Money

One of the most common misconceptions about bond mutual funds, and bonds, is that you can not lose money by investing in them. This misconception is rooted in some truth, but it is not entirely true. When you buy a bond, you are a creditor to the corporation that issued it. As a creditor, you have a claim to the company’s assets if they were to become insolvent. However, there is no guarantee that they are going to have enough assets to satisfy all of their debts. There may be others in front of you in line and they get the assets first. This means that your initial investment is gone as well as your regular interest payments.

With a bond mutual fund, this risk is lowered because you are investing in so many different bonds. However, if several companies go bankrupt that your portfolio has bonds of, the mutual fund performance can suffer. Some bond mutual funds invest in junk bonds, which are bonds with a higher amount of risk. With these funds, it is very possible that several of the companies could go under and hurt your portfolio.

Bond Mutual Funds vs. Stocks

Many investors out there believe that bonds and bond mutual funds are superior to stocks. They think because their risk is lessened with an individual bond that they have found a superior investment tool. While this might be true in the minds of certain investors, stocks do have their benefits as well. Some stocks pay a dividend which provides a regular payment just like a bond interest payment. In addition to that, there is no cap on stocks earnings. Therefore, over the long-term stocks will outperform bonds and bond mutual funds.

$7 Online Trading. Fast executions. Only at Scottrade