For the most part, you should probably understand how a stock mutual fund works by now.  The manager of the fund is in charge of making the buying and selling decisions.  Depending on the investment philosophy, this could mean buying new stocks in the fund, or selling to reduce one’s exposure to a certain stock or industry.  The underlying goal is to beat some kind of index, many use the S&P 500.

Bond funds, also called fixed income mutual funds, operate the same way in principle.  A manager makes buying and selling decisions.  Analysts look at potential investments and talk to the managers pitching different ideas to them.

But they differ in one key way.  When a stock mutual fund wants to buy some stock, he usually goes to an open market like the New York Stock Exchange to make the purchase from another investor looking to sell.  The mutual fund manager is likely seeking appreciation in the price of the underlying stock, though dividends are always good too.

In the fixed income community, there is much less activity in what is called the secondary market.  The secondary market, like a stock market, is where investors buy and sell their holdings from each other.  When we buy a stock, we hope the company will be around forever, so we are assuming the stock has an infinite lifespan.  Bonds are debt, like a mortgage or a car loan, you pay it back over a set period of time and once the debt is settled, it no longer exists.

Analysts and managers at these bond funds usually aren’t buying and selling bonds on the secondary market, though this does occur.  What is usually happening though is the analysts are approached by a company (working through a broker of debt like Goldman Sachs or Citi) with a new debt offering.  It looks something like this:

“Hey Mutual Fund X, Company Y is issuing $50 million in new 10 year bonds for 4%.  You want in?”

Analysts will evaluate the offering and determine whether or not 4% is a good deal. The factors in this decision would be the same as evaluating someone for a loan.  Is 4% appropriate for the company’s credit rating?  But they also must decide whether or not they can get a better deal elsewhere.  If another company with the same risk levels as Company Y was offering 5%, the analyst would pitch the 5% company to the managers.

Analysts sometimes just have a couple of hours to evaluate the offer.  This is because they sellers will take their business elsewhere.  All the bond brokers would have preferred buyers.  On the flip side though, if not enough people are interested in the bonds at 4%, the brokers may have to come back with an offer at a higher interest rate.

Most fixed income mutual funds will buy bonds in the primary market, which is what was described above.  They intend to hold them until the bonds mature, collecting all the payments.  Every once in a while they’ll decide to sell something because their credit rating has suffered or they think they can make a profit selling it to someone.  But most of the time this is not the intention when they purchase the bond.

Though they are both mutual funds, bond funds versus stock funds act in very different ways.  But just like stock funds, some bond funds can be quite risky.  Make sure you always know what you’re investing in before you actually invest.

By The Weakonomist

The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics.

categories: business, investing, personal finance