Most investors give the bulk of their attention to the stock market, because that's where the big growth is. However, stocks can be extremely volatile, and most investors need other types of investment assets in their portfolios to balance their exposure to the financial markets and to meet shorter-term needs. For those investors, adding bonds to their holdings can act as a counterbalance to their stock exposure.

Individual bonds are available to buy and sell through most brokers, but most investors choose to invest in bond funds, rather than picking individual bonds. With hundreds of different bond funds to choose from, it can be challenging to decide which one is best for you. Below, we'll give you all the information you need to understand what a bond fund is and how you can identify the funds that will best serve your financial goals.

Old yellow paper with word Bond prominently featured.

Image source: Getty Images.

What is a bond?

A bond is an investment that's tied to a loan between the bond's issuer and the purchaser. Under the terms of the bond, the initial bond purchaser pays a set amount of money -- usually $1,000 or $5,000 per bond -- to the issuing entity. The issuer gets to keep that money for its own use. In exchange, the issuer agrees to pay interest to the bondholder at set intervals, commonly every six months, until the bond "matures." Once the bond reaches maturity, the issuer pays the bondholder the principal amount back. A bond's maturity date is set before the bond is issued, so investors know up front when they can expect to get their principal back.

There are many different types of bonds, and they are generally sorted into a few different categories. These categories include:

  • Treasury, municipal, and corporate bonds, depending on whether the issuer is the federal government, a state or local government entity, or a private business.
  • Short-, intermediate-, and long-term bonds, depending on the length of time between when the bond is issued and when it matures.
  • Investment-grade and high-yield bonds, depending on whether the issuer's financial condition makes it more likely or less likely to repay the bond at maturity. Generally, the greater the risk that an issuer will fail to repay its bondholders, the higher the yield on its bonds, so most investment-grade bonds have lower yields than most high-yield bonds.
  • Inflation-adjusted bonds, whose issuers pay an amount at maturity that accounts for changes in the purchasing power of money since the bond was issued, rather than a fixed amount.

Bonds typically fall into more than one of these categories. For instance, Treasuries, municipal bonds, and corporate bonds can all be short-, intermediate-, or long-term. Some Treasury bonds are inflation-adjusted, and you can find municipal and corporate bonds that are either investment-grade or high-yield.

The most important feature of a bond is that the stream of payments investors receive when they own the bond is scheduled in advance. For instance, with a 10-year Treasury bond worth $1,000 paying 3%, you know that you'll receive $15 every six months for the next 10 years, and then get your $1,000 back. So long as you hold on to the bond until it matures, there's no possibility of getting more than that, but unless something goes dramatically wrong with the issuer, there's little risk of getting less than that, either.

What's a bond fund?

Bond funds are pools of investments in which large numbers of investors can contribute money toward a commonly held portfolio of bonds. Typically, the bond funds that are available to most investors are either mutual funds or exchange-traded funds.

The way bond funds operate depends on what type of fund is involved. With a bond mutual fund, the fund company accepts orders to buy or sell shares on a daily basis, with all transactions occurring after the end of the trading day. The mutual fund can issue new shares or redeem existing shares at will, and you're always guaranteed to get the net asset value of all of the investments held by the fund when you buy or sell shares.

With bond exchange-traded funds, the mechanisms for trading are a bit different. You can buy or sell bond ETFs at any point when stock exchanges are open for trading, and the price at any given point is determined not by the value of the underlying assets in the ETF, but rather by the market price determined by how much buyers are willing to pay and how much sellers are willing to accept for shares.

Regardless of the type, though, bond funds allow you to invest in a diversified portfolio of hundreds or even thousands of different bonds, even if you have only a modest amount of money to invest. By grouping together a vast array of investors, bond funds are able to invest in a wide swath of bonds efficiently and economically.

Why would I want to invest in bonds?

Investing at least some of your savings in bonds makes sense for most investors. Even for those with long time horizons, the risks of an all-stock portfolio can make some investors uncomfortable. It's true that with stocks, there's theoretically no limit to how much money you can make from a successful investment. If you're one of the first to identify a small upstart that turns out to be the leader of a fast-growing industry, for example, you can earn life-changing wealth. Pick wrong, though, and you can lose everything.

Bonds don't typically have that all-or-nothing nature. Most of the time, the bond will work out exactly the way you expect, with the bondholder receiving interest payments as scheduled and then receiving the agreed-upon payoff at maturity. Although the interest rates that most bonds pay don't match up to the long-term historical returns of the stock market, the relative stability that they offer provides a solid foundation for an investment portfolio.

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 bond 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. However, none of those rate changes affect the bond's terms, and no matter what happens to the market price of a bond, you can always hold on until maturity and receive the predefined payout.

Bond funds generally don't have a maturity date. Instead, they continually buy and sell bonds to serve their investment objective. For example, a long-term bond fund usually concentrates on bonds that mature in 10 years or more. When the maturity date of a given bond hits the eight- or nine-year mark, the bond fund will usually sell it, taking the proceeds and purchasing a new long-term bond to replace it. As a result, if rising rates cause the total value of a bond fund's portfolio to drop, the fact that the fund won't hold its bonds to maturity means that investors might never see the bond fund's price recover. Of course, that can work the other way as well: Rate decreases offer permanent benefits to bond fund shareholders that individual bondholders won't get.

How can I tell which bond funds are the best?

In a universe of hundreds of bond funds, it's important to separate the best from the rest. The top bond funds have the following characteristics:

  • Low expense ratios that minimize the amount of bond income lost to pay for fund management.
  • Large amounts of assets under management. This will spread the fund's costs across a broader set of investors and give the fund more clout within the bond market to purchase attractive bonds at the best possible price.
  • For ETFs, high levels of daily trading volume, which makes it easier for investors to buy or sell shares at any time the market is open.
  • Higher income yields than other bond funds in the same category. That last distinction is crucial, because yields tend to be higher in some bond fund categories than in others, therefore it's important to look at funds with similar investment objectives and portfolios when comparing yields.
  • An investment objective that matches up with your needs. For instance, some investors choose only investment-grade bonds, because they want to minimize the risk that the issuer won't be able to pay them back. However, others like high-yield bonds, because the greater amount of income they generate can more than compensate for the potential losses -- if you're willing to take on the risk of the issuer's default.
  • Special features that appeal to you. For example, income from all municipal bonds is exempt from federal taxes, and if you purchase a municipal bond issued in your state of residence, then your interest payments will be exempt from both federal and state taxes. Meanwhile, inflation-adjusted bonds offer protection against the loss of purchasing power involved with traditional bonds. However, both of these benefits usually come at a cost -- namely, a lower yield -- so the trade-off may or may not be worth it to you depending on your goals.

The top bond funds for 2019 and beyond

Bond Fund

Current Yield

Expense Ratio

Assets Under Management

iShares Core U.S. Aggregate Bond (NYSEMKT:AGG)

3.1%

0.05%

$57.8 billion

Vanguard Total Bond Market (NASDAQ:BND)

3.3%

0.05%

$36.6 billion

iShares iBoxx Investment Grade Corporate Bond (NYSEMKT:LQD)

4.3%

0.15%

$31 billion

Vanguard Short-Term Bond (NYSEMKT:BSV)

2.9%

0.07%

$27.2 billion

iShares TIPS Bond (NYSEMKT:TIP)

1.3%*

0.20%

$21.4 billion

Data source: Fund providers. *Inflation-adjusted yield.

Why these bond funds are the best

With so many different types of bond funds available, it would be impractical to assemble a list that covered every possible combination of characteristics a bond investor might want. However, these five bond funds give investors broad-based exposure to popular types of bonds, and that's a big reason why they have attracted such huge sums of investor money.

The first two funds on the list, iShares Core U.S. Aggregate Bond and Vanguard Total Bond Market, have very similar investment objectives: to provide exposure to the entire universe of U.S. investment-grade bonds. As you can see in the table above, both have low expense ratios of just 0.05%, and both have attractive yields. Their average bond maturities are around 8 years. Both have roughly 40% to 45% of their assets invested in Treasury bonds and securities issued by federal government agencies. Mortgage-backed securities make up another 20% to 30% of their holdings, while about 25% is invested in corporate bonds, and about 5% goes toward specialized types of bonds from foreign issuers.

However, the funds aren't identical. The iShares fund has a bias toward mortgage-backed securities that the Vanguard fund lacks, especially on the government-issued side of the market. Vanguard has a slight preference for Treasury and federal government agency debt, making up for the smaller allocation to mortgage-backed securities. In addition, the Vanguard fund has a slightly smaller percentage of its assets invested in top-rated bonds, which explains its slightly higher current yield. Regardless, for those seeking broad-based exposure to the bond market, either of these funds is a good start.

More specialized exposure

The other three bond funds on the list have features that distinguish them from the most broad-based bond funds. As its name suggests, the iShares iBoxx Investment Grade Corporate Bond ETF invests exclusively in bonds issued by corporate issuers. There's plenty of diversification within the fund, though, as issuers in the banking sector make up just over a quarter of fund holdings, while consumer companies make up another 25%, and communications, energy, and technology companies each account for roughly 10%. That results in average credit quality that's considerably lower than any other fund on this list: 90% of the fund's holdings are in the two weakest categories of investment-grade bonds. Nevertheless, that greater risk comes with a yield that's more than a percentage point higher than its broader-based peers, appealing to those seeking maximum income.

Vanguard Short-Term Bond is a more conservative choice that's geared toward those with a shorter time horizon for their bond investing. The average maturity is less than three years, and the credit quality is comparable to the broader-based bond funds on this list, with roughly two-thirds of the portfolio invested in Treasury and agency securities and the remainder in corporates. The bond fund's price isn't as sensitive to interest rate changes as that of the other funds on the list, but investors must accept a slightly lower yield as a result. Currently, that difference in yield is relatively small, but there have been times when the disparity has been wider due to conditions in the bond market.

Finally, iShares TIPS Bond invests entirely in Treasury Inflation-Protected Securities, known as TIPS for short. The value of TIPS is adjusted for inflation over time. Because TIPS provide protection against the erosion of purchasing power that inflation causes, investors are willing to accept a lower interest rate on them. Yet from a total return standpoint, you have to add the inflation rate back in to get a true sense of how they compare with other bond funds. For instance, with consumer prices rising roughly 2% per year, adding that inflation rate to the 1.3% yield on iShares TIPS Bond gives a total of 3.3% -- very close to what you see from the broader-based funds above.

Be smart about your bond funds

Bond funds can play an extremely useful role in helping you put together an investment portfolio that balances the growth potential of stocks with the lower volatility and clearer risk-reward balance of bonds. If you think bonds deserve a place in your portfolio, then the five bond ETFs above will do a good job of giving you broad exposure to the bond market and the many advantages of investing in bonds.

Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.