Index funds are very popular these days. This applies to bond funds as well. Bond index ETF/funds are very popular these days. We find verity of bond index funds in the market these days. Specific types: treasury, municipal, corporate, mortgage related, government related, foreign government, emerging market, world, high yield. Specific term: short term, intermediate term, long term with verity of maturity. Market weighted and combination of all of the above.
When we try to understand a bond in brief, it seems simple.
If I buy an individual bond with 5 year maturity and 2% return and hold it till maturity, I expect to get 2% return for 5 year plus the principle back after the 5 years.
But bond index funds are not that simple.
If I buy an index bond fund with 5 years maturity and 2% return and after 5 years, it is not necessary that I will get 2% return for 5 years and principle back after 5 years. Return would go up or down during these 5 years. NAV would be higher or lesser after 5 years. Bond funds keep buying and selling part of their holdings to keep the average maturity the same. If the bond fund is not specific, but combination then fund manager would need to keep buying and selling part of the holdings to keep maturity and asset allocation the same. Promoters of index funds often promote simple and low cost indexing to promote their products. But looking a little dip into the index bond fund, it doesn’t look that simple. Low cost is questionable as well – funds need to keep buying and selling in order to keep desired maturity and asset allocation – so more transactions are being executed and more transactions mean more cost.
Now financial industry came up with the new product and investors are talking about BulletShares. These funds fuscous on maturity date and not the maturity duration.
For example if you buy the fund with the maturity date of 2020, the entire bond holding matures in 2020. Right now there are two versions of BulletShares: corporate and high yield corporate, both with target date maturities. As name suggest high yield corporate has higher yield than corporate. Which also means credit quality of high yield corporate is lesser than corporate.