So here's my understanding so far in terms of (individual) bonds. Bonds are conservative investments in which you are essentially lending money to an entity in return for bi-annual payments (coupons) and the return of your full principal after the maturity date. If the company defaults, they are still legally obligated to pay back your full principal, but not necessarily interest payments (?). Early redemption, on the other hand, can result in losses or gains (depending on the current interest rate).
Bonds are often considered conservative investments but I would not use that term, partly because "conservative" has a pretty obscure meaning. People often use that term to mean low risk. Bonds can be anywhere from 0 risk to far more risky than stocks, depending on your definition of risk. In general, high quality bonds maturing in the near future will have more predictable returns than many other investments. US Treasury bonds have, by definition, 0 risk. Yet, a 30 year bond will fluctuate dramatically in price as interest rates change. An overnight bond to a company teetering on bankruptcy on the other hand may have a very solid price.
The legal claim that a particular bond has is specified in a document called a "debenture." Generally there are two different claims that a bond may have. A revenue bond will have a claim against revenue. A company might issue a revenue bond to fund a specific project. For example, a company building a mall might finance it with revenue bonds that are repaid with the revenue from the mall. If the mall does not earn revenue, the company does not pay the bondholders even if the company otherwise makes a profit. The other type of bond is a general obligation bond. A GO bond is a debt owed by the company issuing it and usually must be repaid before stockholders are paid. But among bondholders there are different tiers. Some bonds are subordinated to others meaning they are only paid after the others are paid in full. It is now fairly common to see companies issue bonds to fund credit card debt and that sort of thing.
Then there are issues of security. A bond might be backed by the general corporate assets, by specific properties like real estate, or even by a specific contract. A construction company for example might issue a bond secured by a bridge it is building on which it holds title until completion.
All these things are spelled out in the debenture. If a company defaults on a bond then the bondholders only have a claim on the security pledged in the debenture. For a general obligation bond the bondholders have preference to common stock holders but line up after certain other secured creditors. In recent years it is not at all unusual for bondholders to lose significantly in bankruptcy proceedings.
Here's my understanding of bond funds thus far. Bond funds are managed by a bond fund manager and consist of a large collection of individual bonds. Due to the diversity of funds, they are sometimes considered safer than individual funds. However, a bond fund can gain or lose value (NAV) because the fund manager often sells the bonds in the fund prior to maturity. In other words, there is no guarantee on the value of the principal with bond funds. Thus, [if you wait until maturity] of an individual bond then the worst you can do is break even; but with bond funds the worst you can do is lose all your money. As interest rates rise, bond prices fall, and vise versa. But the advantage of a bond funds seem to be less risk of loses from default and the benefit of diversification, reducing the interest rate risk.
The two main benefits of bond funds are diversification and convenience. Buying an individual bond is possible but commissions/spreads can be rather high and they are not exactly transparent.
The issue with NAV changing is correct but it can also be calculated. It is not a random, unpredictable change. When interest rates rise, the present value of the future interest payments goes down. That's why the bond price goes down. If you own an individual bond your principal value will indeed not go down. But you are kidding yourself to think you have not lost money. The fact that the future interest payments you are entitled to are paid at a lower rate than you could get elsewhere is a loss to you! If you want to close your eyes and pretend you've lost nothing then that's a personal decision.
A bond fund, on the other hand, will give you a number called "duration" or more properly "Macauley duration" that can be used to determine how much the value of a bond fund will go down when interest rates rise. Technically speaking it is the number of years it will take to break even on the current portfolio (or bond) compared to holding a new one at the new rate. But a simpler way to use it is that if a fund has a duration of 3.6 years then, if rates on similar bonds go up by 1% the price of your bond fund will go down by 3.6%. There are of course daily variations in price for other reasons as well including accumulation and distribution of interest payments and market attitudes about the risk in the portfolio.
Taking a look at Vanguard Short-Term Bond Index Fund Investor Shares (VBISX)
, it appears that the annual returns are between 3-4% depending on duration. But then the year-to-date percentage is listed at 0.72%. I’m not sure how to interpret this; is it low because it’s only just past the first quarter of the year and will expect to rise closer to the 3-4% range, or is it simply due to poor performance this particular year?
Probably but I'd need to study it further.
Also, when I look at the distributions for 2011 (for example) I see 16 distributions listed, at roughly 1.8% yield each (average). Doese this mean that someone owning the fund in 2011 would have received an interest payment of 1.8%, 16 times during that year?
There were probably monthly interest distributions as well as semi annual distributions of short and long term capital gains (2 distributions per half) from trading the fund does. But again, I'd have to look kclosely.
If this is the case, why not allocate emergency fund money in a fund like this? Even right now (as of 03/30/2012), with a low 1.54% yield, it’s a lot better than the money markets or short term CD’s that I’ve seen, yet liquid enough for an emergency fund. This particular fund has no purchase fee and no redemption fee.
In my opinion a SHORT TERM bond fund is appropriate for an emergency fund. But you will want to make sure you can write checks against it so that you can access the money in a hurry.