What Are Index Funds and Bonds?

Index Fund Graphic

OpturaDesign / Shutterstock

Investing in bonds means that you are buying the debt of the issuer.

It could be the debt of the U.S. government or an affiliated body like a state, city government, or borrowing authority. You can even purchase the debt of a corporation when you invest in bonds.

What Are Bonds?

Bonds are considered safer than investing in the stock market for various reasons. These reasons are:

  • They have a definite maturity date on which the issuer promises to repay the bondholder who owns the security;
  • A promise to pay taxable or tax-exempt interest as a stated rate in defined intervals, and;
  • The ability to find out the credit rating of the issuer.

That may sound all well and good, but keep in mind that investing in bonds also has its risks. When interest rates rise, bond prices fall. This means that if you need the money and have to sell your bond well before its maturity in a higher interest rate environment, you’re going to get back less than what you paid for it. If the good credit rating is overlooked and you invest in a bond in where the company is at credit risk, they may declare bankruptcy and default on the payment, which could lead you to lose everything you invested. There’s also the risk of a call, in where the issuer can redeem it prior to maturity on a defined rate for a defined price. This usually happens when interest rates are falling, leaving the investor to reinvest the proceeds at a lower rate.

The best way to go about investing in bonds is to diversify your portfolio. Invest in different bonds with different companies and maturity dates.

What Are Index Funds?

Aside from investing in trading bonds, you can also build up your portfolio by investing in bond index funds. When you do this, you are investing in an already established portfolio that is created and managed to pursue a specific investment income.

Index bond funds offer a significant advantage over traded bond funds. Most important is their consistent performance.

Many times, an index bond fund will outperform a traded bond fund — and at a lower operating expense. This is because bond fund managers have a greater difficulty beating the indexes. Unlike stock, index bond funds vary in their gross returns. Once an investor has chosen a level of credit quality and average maturity, most bond funds will have a similar gross yield. It is really expensing more than anything that differentiates bond funds, and it is index funds that are the leaders in keeping expenses down. In stock terms, index bond funds are the blue-chip of the bond-investing world.

Not only that, but index bond funds are a conservative investment. They pay out a regular return, which eliminates the need to seek out superior returns. When you invest in a bond index fund, you’ll receive monthly dividends from the fund that include interest payments on the fund’s underlying securities plus any capital appreciation in the prices of the portfolio’s bonds.

As with other types of mutual funds, bond index funds have a net asset value (NAV). The NAV is the dollar value of one share in the fund. It is the price that investors pay or receive when they buy or sell shares in the fund.

What Should You Invest In?

Deciding on which types of bonds to invest in is not an easy decision.

It depends on the type of person you are. Do you like to take risks with your portfolio, hoping for a bigger return on your money? Or do you like to play it safe and invest in something that is going to pretty much have a guaranteed return?

The easiest way to go about all this is to talk to a financial advisor. Don’t try and play the markets yourself without arming yourself with the knowledge you’ll need to build a successful portfolio. That’s a fool’s game.

Index Fund Graphic

OpturaDesign / Shutterstock

Joshua Williams

Joshua Williams

Joshua is a freelance writer with years of experience blogging about business and finance, and a whole host of other things too. When he's not writing, he enjoys camping with his dog, a golden retriever named Oakley.