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How to Diversify Your Passive Income - Using Bond Funds

By Edited Nov 13, 2013 0 0

One definition of retirement is the point at which your passive income completely pays your living expenses and there is little or no work you need to do to maintain the income.  It is safest when that income comes from multiple sources. In other words, you need to diversify that income.

There is much written these days about passive income streams. Often it centers on internet marketing. Well, a much older form of passive income exists.

Dividend and interest income together form a very productive base for your passive income.

In this article you will learn about interest income from bonds, specifically bond mutual funds.

A bond is a loan you make to a company or government. When you own a bond the company that issued the bond has the legal obligation to pay you the stated interest rate each year and at the maturity of the bond they are obliged to pay you your principal back.

 For example, a 10 year $1,000 bond at 5% from XYZ Company will pay you $50 (5% of $1,000) each year for 10 years and at the end of the 10 year period XYZ company will return your original $1,000. So you gained $500 and now have a total of $1,500.

A bond fund is a type of mutual fund in which the managers of the fund invest in bonds only. They pool your money with other investor’s money and buy many bonds from different companies. This way you are diversified without buying hundreds of individual bonds.

They also buy bonds of varying maturities meaning not only do you have diversity among different companies you also have diversity among different lengths of time. Some will be close to maturity while others may be 20 or 30 years from maturity. Diversity of different lengths of time is important for more stability in the value of your fund.

When a bond inside the fund matures, the managers of the fund choose a new bond to invest in. There is nothing you need to do when this happens. Because the money from matured bonds is reinvested into new bonds, a bond fund is perpetual and has no set ending date like individual bonds do. This is good news for those who want to be very hands off in their investing and take a passive income approach. You can buy a bond fund from a well known company and leave it forever. Although the bond fund is perpetual, it is completely liquid to you and you can get out at any time.

Bond funds have two main risks that the investor should be aware of.

The first is credit risk. Each bond in the fund is guaranteed by a particular company, but if that company is in poor financial condition they may not be able to pay you the money they owe you. Companies have a credit rating similar to an individual’s a credit score. It is the job of the bond fund managers to continually monitor the credit risk of each bond in the fund. They will sell a bond if they feel it is not longer a safe place to invest the bond holder’s money.

A bond fund has parameters detailing what credit ratings are acceptable within the fund. There are funds that only invest in low rated or junk bonds and there are funds that only invest in the highest rated companies. Of course there are also funds that specialize at every point in between these two extremes.

The overall fund itself is given a credit rating which is the average rating of all the bonds inside of it. A3 or AAA is a very good score reserved for only the safest bond funds. CCC is bad and should be avoided by most people. It is up to you to decide how aggressive or conservative you want your bond fund to be. Junk bonds pay higher rates of interest which means higher passive income for you, but you will see the overall price of the bond fund rise and fall a lot over time. The volatility of junk bond funds behaves more like stock funds. High credit quality bond funds will pay you less income, but will be more stable in price.

The 2nd main risk that bond funds have is interest rate risk. This is the risk that movements in the overall interest rate environment will cause the value of your bonds to rise or fall. This risk is cyclical as rates tend to rise, plateau then fall and bottom out before repeating the cycle again. If you hold the fund long enough you will experience each stage of the cycle. If you’re in the fund for the long term as you should be, interest rate risk is not something you need to be afraid of. You will however notice the value of your fund rising and falling over the years.

Bond funds are perpetual and will continue to pay you income, usually monthly, forever. The exact amount of that income though will vary each month. In well run bond funds you will only notice gradual changes in the dollar amount they’re paying you each month.

The changes in the monthly income that the bond fund provides are again due to changes in the interest rate environment. When interest rates are rising you will notice your monthly income slowly rising. This is because when bonds in the fund mature, the managers reinvest the money in new bonds that are paying more interest. When rates are falling though, the monthly income will slowly go down because the new bonds which the managers buy are not paying as much interest. You must grow accustomed to such changes.

Since the exact dollar amount of income from bond funds change over time, you should leave yourself with some wiggle room. Never be dependent on every bit of the income or you will be in trouble.

It’s wise to take your excess interest each month and reinvest it back into the bond fund so that your income will generally rise each year. Hopefully this will outpace inflation. You may also choose to reinvest the excess income into one of your other forms of passive income. This will achieve the same result.

When choosing a bond fund be on the lookout for front end sales charges, or loads these are called “A Share” mutual funds. “B Share” or back end fees to get out of a fund exist too, but are less common. I you are not working with a financial advisor there is absolutely no reason to ever pay one of these sales charges. If you are working with an advisor and they present a fund to you with a front or back end load, then it is up to you to decide if the advisor is helping you enough to justify the fee. The fee is usually 4 to 5% of the total amount that you put into the fund.

Internal expenses are another way that mutual funds charge you. All funds have internal expenses just to do business and pay their managers. When the internal expense is less than 0.8% you’ve usually found yourself a low cost fund.

Often times, part of the internal expense is a special fee called a 12-b-1 fee. This is just a fancy name for a sales charge. It goes to the broker who sold you the fund. Again, if you’re not using a broker avoid funds with a 12-b-1 fee.

Bond funds are an important component of any long term passive income plan. It's important to understand the risks before you buy. Watch out for hidden sales charges. Then relax and enjoy the monthly income it provides while you busy yourself with activities you enjoy.


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