A fixed income fund is a type of fund that pools money from many investors and invests it in fixed-income securities such as bonds. Fixed income funds are sometimes referred to as bond funds, and they can be either mutual funds or exchange-traded
funds. They are frequently used when planning for retirement.
Mutual fund shares are continuously issued and redeemed by their fund company. The shares are priced according to the net value of their underlying assets. They do not trade on exchanges or over-the-counter, and they are generally priced only once a day.
Exchange-traded fund (EFT) shares are similar to mutual fund shares, but ETFs trade on exchanges – much like individual stocks. Like stocks, ETF share prices can fluctuate throughout the day, and their prices are based on supply and demand – not on the value of the underlying assets.
Types of Fixed Income Funds
Fixed income funds generally invest in bonds, but there are many different types of bonds that these funds can hold.
Bonds are primarily categorized by their issuer, and the two main issuers of bonds are governments and corporations.
Treasury bonds are issued by the U.S. Treasury. They are considered risk-free because they are backed by the full faith and credit of the U.S. Government. Other government bonds include municipal bonds. Interest income from these bonds, issued by state and local governments, is tax-free at the federal level.
Corporate bonds are not perceived to be as safe as government bonds, but they can still be high-quality. Investment-grade bonds carry high marks from rating agencies but have a higher rate than government bonds. On the other end of the spectrum, high-yield, or “junk” bonds are issued by entities with a high risk of default. To compensate for this added risk, these bonds offer higher interest rates.
In addition to categorizing fixed income funds by the issuer, funds also usually specify the duration of the bonds they hold. This is usually expressed as low, medium, or high-duration.
Taxation of a Fixed Income Fund
For fixed income fund investors using taxable brokerage accounts, there are three potential ways to be taxed.
First, there is interest income. Bonds pay interest, usually twice per year, and this income is taxable to the individual investors that own shares of the fund.
There is also the potential for tax on capital gains realized by the fund. If, for example, the fund sells a bond before it matures at a price higher than what it paid for the bond, investors in the fund are usually responsible for capital gains tax. Whether the gain is short-term or long-term depends on how long the fund held the security, not how long the investor held the shares.
The third way that fixed income fund investors can be taxed is by the gains on their shares. As with the sale of any other security, if you buy shares of a fixed income fund and sell them later at a profit, the gain will be taxed.
For those holding fixed income fund shares in a retirement planning account such as an IRA, taxation on income or gains from the fun will be deferred until the investor actually withdraws money from the account. All withdrawals from the account will then be taxed at the ordinary income tax rate.