Despite the availability of a large variety of bond funds in the market, it should not be difficult to select one that fulfills your requirements. Bond funds may be mutual funds or closed end funds. The purpose in any case is to derive income. Normally, they carry the option of getting dividends or reinvestment of the same. You get bond funds specializing in particular types of bonds like government bonds, municipal bonds, high yield corporate bonds and taxable or tax free bonds etc. On conducting a comprehensive research and following the steps noted below, it becomes easy to select a bond fund that perfectly suits your requirements:
1. At the outset you should define the reason of investing in bonds and be clear of your goals. You may choose to invest in such funds for the income they provide. At the same time if your income falls in higher tax bracket, you may consider investing bonds that provide tax relief. Keep in mind that there is no fixed date for maturity of such bonds and there is no assurance of principal.
2. You should also decide beforehand the time for which you can afford to stay invested. That better prepares you to assess your tolerance to market fluctuations. You may be looking forward to make savings for buying a house and thus may not find it very appropriate to invest in long term funds. The usual tenure of a short term bond is three years and bonds having intermediate term last for five to eight years whereas long term bonds last for ten years or even more.
3. Know your risk taking capacity. It helps you deciding the amount to be invested and the extent to which you can stomach market variations. Bond funds are associated with these risks: income, rate of interest, index sampling, credit and the management of your chosen fund. The risk in interest rate arises with the likelihood of bond prices coming down due increasing interest rates. Obviously, with interest coming down, there is the risk of falling income. Index sampling risk arises due inappropriate selection of securities which affect the anticipated performance of the fund. Credit risk is caused due inability of the issuer to make payments towards interest and principal in time and the resultant drop in the price of bond. Risk of management of fund refers to the inapt choice of investments made by the fund manager, resulting to under performance of the fund, compared to other funds having similar investment goals.
4. You should keep reviewing your portfolio lest you should invest a bit too much in a particular group of similar funds. That makes you more vulnerable to risks, while depriving you of a diversified portfolio.
5. Look at the costs. Be informed of the penalties and fees you are liable to pay for making early withdrawals. Find out the expense ratio and sales charges applicable, if any. The lower such costs, the more is your earning from investment.