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Difference Between Bonds and Bond Funds

Before investing money in any income-oriented fund from Principal Investors Fund, Inc. investors must understand some of the basics of bond funds. This understanding is particularly important to investors moving from money market funds, certificates of deposit, or other similar savings vehicles into bond funds. Like any other investment, bond fund investing entails some risk.

A bond is an IOU issued by a private company, municipality or government agency. In exchange for the use of investors' money, bond issuers agree to repay the amount borrowed (principal) on a specified date. In addition, the issuer agrees to make periodic interest payments over the life of the bond.

If they choose, bondholders may sell their bonds in the open (secondary) market prior to maturity. However, the market values of bonds may differ from their face values. Market values are determined by the difference, if any, between yields available on new issues and the coupon yield assigned to existing bonds. For example, if you plan to sell a bond with a coupon yield of 7% when similar new-issue bonds are paying 6%, your bond should sell at a premium, i.e., above face value. Conversely, if current rates are at 8%, your 7% bond will typically sell below face value, or at a discount.

Because bond mutual funds invest in many different bond issues, neither the dividend payments nor maturity dates of the fund are fixed. As a result, bond fund investors don't lock in an interest rate or maturity date.

A bond mutual fund is an ongoing investment vehicle which has no maturity date. Professional money managers buy and sell bonds for the mutual fund portfolios in accordance with the funds' objectives. When bonds within the fund reach maturity, the proceeds are used to purchase different bonds for the portfolio.

Bond funds offer liquidity. Shareholders may redeem shares if they need access to their money. The value of shares at the time of redemption may be worth more or less than the purchase price, depending on value changes.

The value of bond fund shares (known as net asset value) changes as general interest rates change. The extent of value change depends on the type, quality and maturity of bonds held in the fund portfolios. In addition, share values can change based upon the managers' activities of buying and selling bonds in the portfolio.

The Risk/Reward Trade-Off

Fundamental to all investments is the opportunity for greater reward in exchange for the willingness to assume greater risk. Bond funds are no different. Because they involve greater risks than money market funds, CDs or other deposit accounts, bond fund investments offer the potential for higher earnings.

CDs and deposit accounts offer federal insurance against loss up to certain levels and fixed rates of return. Money market funds seek but cannot assure a stable share price and are neither insured nor guaranteed by the U.S. Government. Bond funds are not insured, and the principle and yield will fluctuate with changes in market conditions. However, in exchange for the potential risk of loss, bond fund shareholders have greater potential for reward.

Not all bond funds have the same degree of risk; some are riskier than others. The degree of a given fund's overall risk is based upon its combined exposure to three specific types of risk: credit risk, inflation risk and interest rate risk.

Credit Risk

Credit risk refers to the ability of the bond issuer to make interest payments to bondholders and return principal at maturity. Various bond rating firms issue ratings which are based on thorough analysis of internal and external factors affecting the issuer. These ratings are based solely on the creditworthiness of individual bonds, not on the stability or safety of a bond fund. Because bond funds represent a diversified pool of bonds, the impact of one default on the fund share value will generally be minimal compared to owning that single bond. Here are the definitions of individual bond ratings by two popular ratings firms:

Inflation Risk

Inflation risk is the potential loss of purchasing power if investment returns fall below the inflation rate. To avoid loss of purchasing power and realize a positive real return (i.e. net of inflation), investors should seek returns higher than the rate of inflation.

The price of postage stamps tells the story of purchasing power. In 1980, ten stamps cost $1.50. Today, that same amount would purchase only three postage stamps! Are your investments keeping pace?

Interest Rate Risk

Interest rate risk describes the potential impact on bond values resulting from changes in interest rates. When interest rates rise, bond values fall. When rates drop, bond prices rise. The degree of change depends on factors which include length of maturity, rating, and variables relating to a specific issuer, its industry or geographic location.

Before investing in mutual funds, investors should carefully consider the investment objectives, risks, charges and expenses of the funds. This and other information is contained in the free prospectus, which can be obtained by:

• Calling 1.800.222.5852 and requesting a prospectus
• Downloading a prospectus (A, B & C shares)
• Downloading a prospectus (J shares)
• Requesting a prospectus be mailed to you (A, B & C shares)
• Requesting a prospectus be mailed to you (J shares)

Please read the prospectus carefully before investing. See the mutual fund section of our site for a description of the different share classes.