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Bond Fund Risks

Bond Funds

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Your bond risk exposure changes based on which bonds you select. This remains equally true for bond funds. Bond funds composed of bonds vulnerable to a particular weakness will carry those weaknesses in the fund. If the bond type you are choosing has a particular sensitivity to default risk, interest rate changes, inflation risk, currency exchange risk, or any other risk, a fund built from those bonds will also carry that sensitivity. A skilled manager will have control over those risks, or will be able to mitigate them, but sensitivity will remain at some level. This is something you should be aware of as an investor.

Certain bond fund risks can be controlled by you. If you are primarily concerned about purchasing power loss, purchasing inflation adjusting bond funds will ensure returns grow with price increases. Inflation adjusting bond funds exist for several nations, but they only correct price rises for the issuer’s domestic market. If your domestic inflation rate is higher than theirs, you will still lose purchasing power in these bonds and bond funds. See our inflation adjusting bond section for more information.

Bond Fund Risks: Default Risk

If you are primarily concerned about default risk, invest in bond funds that focus on investment grade bonds or high quality sovereign bonds. Bond funds focused on these investments are unlikely to default. Powerful Central banks such as the USA, Japan, England, or the European Union banks can print their own currency to pay their bonds. High grade corporations earn enough steady cash flow to meet interest and principal demands. You can also easily diversify default risk by investing in bond funds targeting differing bond markets. If Japan suffers an economic crisis resulting in credit defaults, owning American or British bonds will help ease the pain. Spreading your coverage globally helps reduce the total impact of a wave of defaults at various credit ratings.

Bond Fund Risks: Interest Rate Risk

If you are primarily concerned about interest rate risks, you need to pay attention to the effects of bond durations. The duration is the amount of time it will take the bond to deliver half of the total payments. The duration is weighted, or adjusted to factor in the time value of money. Duration depends on the balance of yield and maturity. Bond funds have no maturity since they constantly reinvest into bonds, but average duration does play into the relation of your bond fund with interest rate risk. Higher durations result in higher interest rate risk exposures. In comparison to short term bonds, longer bond maturities and lower yields suffer greater negative impact from interest rate increases. No one wants to earn below market rates for long periods of time. Investors will flee long term duration bonds with below market yields more than they will be driven from short term durations. A higher duration will decrease in value more than a lower duration, actively affect the prices managers can purchase and sell while trading.

Bond Fund Risks: Taxation Risk

If you are concerned about taxation, bond funds which invest only within your domestic nation, province, state, or municipality can help you gain returns which are tax reduced, or even exempt. You will need to check income tax laws and capital gains taxation to see if bonds issued by your various levels of government are tax reduced or tax exempt investments. Mutual funds which specialize in municipal, provincial, or state bonds often qualify for tax reduction or exemption. As an example, bond funds within the United States are exempt for an investor if the fund contains mostly municipal bonds within their same state.

In many nations mutual funds are not taxed for their profits, but their shareholders are charged their obligations. The tax bill is passed to you while funds constantly buy and sell securities on your behalf. As a result, you will encounter capital gains or income taxes annually even if you do not cash out of the bond fund. You lose control over taxation timing when you utilize to mutual funds.

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