Bond funds have no fixed
maturity
or set interest payment schedule because the
underlying
bonds are bought and sold constantly on the
secondary market.
This makes bond funds especially sensitive to the impact of interest-rate changes on bond prices.
As with individual bonds,
interest-rate risk
increases as the average maturity of a bond fund increases. So a long-term bond fund with maturities of 10 years or more will lose more value when interest rates climb than a short-term fund holding bonds that mature in 1 to 3 years. And when interest rates are falling, investors in long-term bond funds can expect the funds to appreciate in value more than shorter-term funds.
Even though bond funds can fluctuate in value, that doesn't mean that investors should avoid them when interest rates are expected to rise. For many investors, bond funds make it possible to build a
diversified
bond portfolio, since you can invest in a bond fund for less than you would need to buy bonds on your own. And diversification is an important strategy for limiting the impact of
interest-rate
and
inflation
risk in your bond portfolio.
Bond trading
Bond funds — and individual investors who trade bonds — buy and sell bonds in the expectation of making money from their appreciated value. If an older bond's yield
is higher than newly issued bonds, other investors and traders may want to purchase the older bond. As increased demand for the bond drives its price
up, investors stand to realize greater profits by selling the older bond for a
capital gain
rather than holding it to
maturity.
Bond funds have no fixed
