Bond funds, including mutual funds and exchange-traded funds (ETFs), are popular because they have appealing features. But they do have some significant disadvantages.
Bond funds are liquid and are less volatile than equity funds, and they typically pay monthly income. They come in many flavors, from the lowest-risk offerings like short-term US Treasury funds to riskier investments such as junk-bond funds that offer higher rates and potentially higher returns. Municipal bond funds pay interest that’s free of federal income tax and sometimes state tax.
But there is one big downside. When interest rates rise, the share prices of bond funds decline because lower-paying bonds will be worth less. In 2021, Morningstar’s core bond index dropped 1.61% while its US government bond index fell 2.28%.