Time Based Bond FundsBond Funds
Many bond funds are categorized by their length, in addition to their target sector or bond type. Time Based Bond Funds divide into the length of bonds they select for investment. Some of these are corporate bond funds, investing only in bonds released by corporations. Some invest in government bonds within a time frame, and others invest in agency, municipal or other bond types. For example, you will see titles such as “High-Yield Mid-Term Corporate”. This shows the targeted subtype, term, and bond categorization. If they don’t display a time frame, but list the average duration or average time to maturity, this list will help you decipher the category.
Short Term Bond Funds
Short and ultra-short term bond funds invest in fixed income securities that have relatively little time until maturity. These funds purchase bonds that rapid deliver small returns that can be fairly quickly reinvested.
The shortest term bond funds are “ultra-short terms”, which have average maturities below roughly 1 and half years. Short term bonds have average maturities of roughly 2 to 3 years. Ultra short term bonds have a slightly lower rate of principal loss and a slightly lower interest rate risk than short term bonds. These bond funds feature the lowest exposure to interest rate risks, the chances that rises or falls in the rate will affect the trading price. Since these funds invest in assets that will soon mature, the money is locked in bonds a short period of time, and will soon be reinvested in the market at current rates. Short term bonds are affected by interest rate changes far less than medium or long term bonds. If rates rise, quick maturities mean funds will be able to reinvest at higher rates soon.
The downside is they are heavily exposed to reinvestment risk. This is the risk the fund will have to invest mature bond profits at lower rates of return than before. If rates fall, the quick maturities result in the cash rapidly being reinvested at lower rates. Ultra short term bonds suffer the maximum possible reinvestment rate risk found outside of money market funds. Short term bonds suffer high reinvestment rate risk.
Mid Term Bond Funds
Midterm bond funds invest in fixed income securities with moderate maturities. These bonds typically last between four and seven years. Most investors transact bonds within the midterm range, avoiding having to incur high reinvestment risk from short terms, and interest rate risk from long terms.
These bond funds balance interest rate risk and reinvestment rate risk. If rates rise in two years, a bond that lasts five years will suffer a decrease in traded price, but not as significantly as a nine-year long term maturity. The fund will suffer three years of below market rates if they don’t sell. The nine-year bond would suffer six. If rates fall in two years, the extra three years of maturity will save the fund from immediately having to reinvest at the new lower rates. Short term bonds would quickly force them to reinvest at lower interest rates. The long term bond would offer the most benefit, staying above market rates for a seven years.
Long Term Bond Funds
Long term bond funds invest in some of the longest possible bond maturities on the market. Long term bonds pay interest for 8 years or more. As a result, these bond funds have the lowest possible reinvestment rate risk exposure of all bond funds. If the fund buys 10 year bonds and the rates go down in 2 years, it doesn’t matter. They still have 8 years at the higher rates and their value increases during that time period.
Unfortunately, they also have the highest interest rate risk. If the rates rise, these bond funds are locked into many investments that won’t mature for a long time. They could sell these bonds, but who wants to be stuck receiving below market rates for potentially 8 years? The sale will be made at deep discounts to the bonds purchase value. The alternative for the management is to hold onto the bonds for up to a decade while receiving lower rates.
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