Bond funds have goals for their time period of asset ownership; they can be short, medium and long positions. As bonds in the bond fund mature (or are sold by the fund), they are replaced with new bonds matching the fund goals. For example, a long term government bond fund will always hold long term government bonds. A long position corporate bond fund would also hold long corporate bond funds etc. This is accomplished by selling the bonds they hold as they move towards maturity and replacing them with new bonds that are further away from maturity. Interest rates always are in a state of volatility, so when the fund sells the existing bonds in the portfolio the new bonds they replace them with are mostly will have a different interest rate.
There are several disadvantages from owning bond funds, here are three:
1. Interest Rate Risk: Bonds have interest rate risk and in a declining market this would cause the value of the bonds in a portfolio to increase. If interest rates increase, a mutual fund shareowner having sold a bond or bond fund could receive less than their initial investment. This is called the rule of inverse value. Any bonds held to maturity would not be exposed to risk because the funds would simply be returned to the bond issuer in return for the funds paid to initially purchase the bond. Rarely do bond mutual funds hold bonds until maturity, the bonds in a mutual fund are normally bought and sold as the fund manager attempts to increase the overall value and yield of the mutual fund. Buying and selling can cause two things to happen negatively to the bond mutual fund shareholder, exposure to fees for the acquisition and disposal of bonds and the potential exposure to unwanted tax liability.
2. Credit rating changes and defaults: Often bonds have changes in their strength and bond ratings are adjusted. If a bond increases in ratings the bond could increase in value should the bond be sold prior to maturity. The opposite is true, bond rating which are lowered, can cause the actual bond held by the mutual fund, value to lower should the bond be sold prior to maturity. In a decreasing interest market, as bonds mature and are replaced, it is possible the new bond purchased could have a lesser interest crediting rate. Overall over time interest yield from the bond fund could decrease.
3. Taxes: Bond mutual funds buy and sell individual bonds in their holds almost daily. Many of these bonds could be subject to tax liability, ordinary income if ownership if short and capital gains if the bonds reach the 18 month ownership time period. Current capital gains tax rates are 20% of any gain. The tax liability is passed down to the individual share owners of the bond fund. Bonds held to maturity would have no tax liability, the funds are simply returned at the end of the time period.