What it means
Instead of buying individual bonds, an investor in a total bond fund buys units in a fund that holds hundreds or thousands of them. The fund collects the interest from the underlying bonds, pays most of it out as income and reflects changes in bond prices in its unit price.
Many total bond funds are index funds, meaning they copy a broad market index such as an aggregate bond index rather than trying to beat it. Others are actively managed, with a manager choosing bonds in the hope of better returns, usually for a higher annual fee.
The fund's behaviour is driven mainly by interest rates and credit quality. When market interest rates rise, the prices of existing bonds fall, so the fund's value dips, and when rates fall, prices rise, with the size of the move depending on the fund's duration (a measure of how sensitive its price is to changes in interest rates).
Total bond funds are often used as the stable part of a portfolio alongside shares. Treasury teams, pension schemes and individual investors use them to earn more than cash while keeping risk below that of shares, although they are not risk free and can lose money in a year when rates rise sharply.
When comparing funds, the main details to check are the expense ratio (the annual cost as a percentage of assets), the average duration, the average credit quality and the yield (income as a percentage of price). Costs matter more than usual in bonds because returns are modest, so a small fee takes a large bite.
Note that the name "total bond fund" is a description, not a regulated category, and different providers fill it with different contents. Always read the fund's factsheet to see what it actually holds, for example whether it includes high yield bonds or foreign bonds.
In practice
Real-world examples.
Example
A 45-year-old employee puts 30% of her retirement savings into a total bond fund and 70% into a share index fund. She expects the bond holding to cushion her balance when share prices fall.
Example
A small manufacturing company has $1,500,000 of surplus cash that it will not need for three years. The treasurer places it in a total bond fund with a short average maturity, accepting a small risk of price loss in exchange for higher income than a bank deposit.
Example
A charity's investment committee compares two funds. One tracks the broad bond market for 0.05% a year and the other is actively managed for 0.60%, and the committee chooses the cheaper fund unless the active manager can show a convincing record after fees.
Formula
Calculation
Total return = (Ending unit price - Starting unit price + Income distributions) / Starting unit price
Suppose an investor buys units at $10.00 each. Over the year the unit price falls to $9.80 because interest rates rose, and the fund pays out $0.40 per unit in income. Total return = (9.80 - 10.00 + 0.40) / 10.00 = 0.20 / 10.00 = 2.0%. An investor who looked only at the price fall of 2.0% would have missed that the income of 4.0% more than offset it.Case study
Seen in the real world.
Linden Trust is an illustrative, fictional foundation with $10,000,000 invested, of which $3,000,000 sits in a total bond fund. In a year when central banks raised interest rates, the fund fell in price by 5.0%, and a trustee asked whether the bond allocation had been a mistake.
The finance officer showed that the fund had also paid income of 3.5%, so the total return was a loss of 1.5%, or $45,000, on the $3,000,000. Over the same year the foundation's share holdings had fallen by more, so the bond fund had still done its job of reducing the overall loss.
The trustees decided to keep the allocation, but to add a small holding in short-term bonds to reduce rate sensitivity. The illustrative lesson is that a bond fund should be judged on total return and on its role in the whole portfolio, not on the price move alone.
Watch out
Common mistakes.
- Assuming a bond fund is as safe as a bank deposit, when its unit price can fall, especially when interest rates rise.
- Judging the fund only by its yield, which can be higher because the fund holds riskier bonds or longer maturities.
- Ignoring fees, even though a 0.50% annual cost takes a big share of a bond fund's typical income.
Questions
People also ask.
What is the difference between a total bond fund and a single bond?
A single bond returns your principal at maturity if the issuer pays, while a fund never matures, so its price keeps changing and there is no fixed date on which you are repaid.
Does a total bond fund pay a fixed income?
No, the income varies as the fund buys and sells bonds and as interest rates change, although it tends to be steadier than dividends on shares.
When do total bond funds lose money?
They tend to fall when interest rates rise quickly or when credit losses increase, because both reduce the market value of the bonds inside the fund.
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