Investments in hybrid mutual funds, containing some bonds, and bond mutual funds, containing primarily bonds, accounted for about 27 percent of all investments, according to the Investment Company Institute's February 2010 data. Bonds have become an important part of mutual fund portfolios for a variety of reasons. However, if you are new to investing, you might be confused as to how fund administrators calculate bond prices and yields.
Establishing Initial Prices
The price of a bond depends on how long until maturity and the risks the investor is assuming. There are three main risks involved with bonds. The first is credit risk, which is based on the expectation that the issuer will be able to pay interest earnings on time and to redeem the bonds at full value when mature. Prepayment risk refers to the possibility that the issuer will decide to redeem outstanding bonds prior to maturity, thereby avoiding additional interest payments and forcing you to find another investment vehicle at a time that might not be the most opportune for maximizing your return. Creditworthiness and the possibility of prepayment can impact the initial price of bonds. The third risk you assume when purchasing bonds is whether inflation will outpace the interest rate offered.
The value of a bond is impacted by changing interest rates more than any other factor. This is because the majority of bonds are sold with a guaranteed interest rate stated at the time of sale. If interest rates decline, the price of the bond must increase to ensure equilibrium between the guaranteed and current interest rates. If interest rates increase, bond prices decline because the guaranteed rate is no longer as attractive to investors. Should the issuer's creditworthiness decline, bond prices may also decline.
The yield is a calculation of the amount of interest generated by the bond less the fees for the fund management. There are two methods of computing yield, the historical method and the standard established by the Securities and Exchange Commission called the SEC yield. The historical method analyzes the past performance of the bond to predict future earnings. The SEC yield measures the income you would receive each year, based on the bonds in your portfolio during the previous 30 days, assuming you reinvest all dividends and hold every bond until it matures.
Funds can maximize bond yields by carefully choosing bonds to include. Bonds will the longest maturity or the greatest risks tend to offer higher yields. Such bonds typically have prices that increase correspondingly. Funds holding bonds with shorter maturities often have lower yields, but share prices also tend to remain more consistent.
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