When a stock mutual fund makes a year-end distribution of capital gains and income, the fund’s share price drops by the amount of the distribution.
But many bond funds distribute income to shareholders on a monthly or quarterly basis, and in this case, the bond fund’s share price does not drop by the amount of the income distribution.
Stock funds and bonds funds collect income dividends in different ways
Stock funds collect dividends (as well as any capital gains that are realized) from the underlying stocks and incorporates these into the funds’ net asset value, or daily share price. That’s why a stock fund’s share price drops when the fund makes a distribution – the distribution comes out of the fund’s total net assets.
With bond funds, the internal accounting is different: Dividends accrue daily, and are then paid out to shareholders every month or quarter. Bond funds collect the income from the underlying bonds and keep it in a separate internal “bucket.”
A bond fund calculates a daily accrual rate for the shares outstanding, and shareholders only earn income for the days they actually hold the fund. For example, if you buy a bond fund two days before the fund’s month-end distribution, you would only receive two days’ worth of income that month. On the other hand, if you sell a fund part-way through the month, you will still receive a partial distribution at the end of the month, pro-rated for the days you actually held the fund.
Not all bond funds distribute income monthly or quarterly. Some funds distribute income on an annual basis. In this case, the fund incorporates the income from the underlying bonds into the fund’s NAV, like a stock fund, and distributes it once a year to shareholders.
Remember that bond funds (and ETFs) may also distribute capital gains. Capital gains are incorporated into the NAV and when a bond fund or ETF makes a capital gains distribution, the fund’s share price will drop by the amount of that distribution.