Alan Davis Management - What are the pros and cons of bond funds?

Bond funds are useful for investors because the minimum investments required to invest directly in individual bonds are usually sizable. For instance, putting together a relatively diversified portfolio of 20 different municipal bonds would likely cost you $100,000 or more. Bond funds, by contrast, often let their shareholders start investing with as little as $100, and you can still get the same diversification.

In addition, the bond market is a lot different from the stock market when it comes to individual investor participation. With stocks, all you have to do is get an online brokerage account, and you can typically buy or sell shares at extremely low commissions. With direct access to exchanges, your stock trade executes in a fraction of a second, and beforehand, you can easily tell what the prevailing market price is and predict quite well what your final trade price will end up being.

However, the bond market is geared much more toward professional traders, with financial institutions maintaining tight control over the market. It's hard for ordinary investors even to get up-to-date bond prices, let alone find resources and tools similar to the ones that so many brokers provide to their stock-trading clients to help them with their investing. By investing through a bond fund, you turn over the responsibility for finding and buying actual bonds to the manager of the fund, and the trading and pricing of the fund shares is much simpler and more transparent.

However, bond funds do have some downsides. The most important is that bonds funds charge fees for their management and investment services. All bond funds pass through their expenses to fund shareholders through what's known as the expense ratio, taking a small percentage of shareholders' assets to cover costs. Expense ratios can run from 0.05% to 1% or more on an annualized basis. The greater the ratio, the more money you'll lose to fees. However, because the expense ratio is typically taken from the income produced by the bonds in the fund's portfolio, you won't actually see the amount you're paying on your financial statement; you'll just get a slightly smaller income distribution from the fund, because the fees have been deducted from the payout. Some bond mutual funds also charge up-front sales fees that can amount to several percent of your initial investment. These sales loads aren't worth paying, as the money goes straight to the investment professional selling you the mutual fund shares, and none of it goes to the fund itself.

Another risk to be aware of is that bond fund prices can fluctuate dramatically over time, and unlike individual bonds, bond funds offer no guarantee that you'll eventually be able to cash out at a fixed price. Remember that new bonds are continuously coming to market, and the prices of existing individual bonds tend to move when prevailing interest rates in the market change. When rates on new bonds go up, the value of previously issued individual bonds falls, because the older bonds' lower rates mean they pay investors less interest than newer bonds. When prevailing interest rates fall, conversely, an individual bond's price typically rises, because the interest rate on the existing bond now looks more attractive than what newer bonds are offering.