As the name suggests, bond mutual funds invest in bonds and other debt securities. As such they are conservative investments that aim to protect the invested principal while paying out a regular income, rather than taking on more risk in search of superior returns. If you invest in a bond fund you’ll receive monthly dividends from the fund that include interest payments on the fund’s underlying securities plus any capital appreciation in the prices of the portfolio’s bonds. As with other types of mutual funds, bond funds have a net asset value (NAV) that is the dollar value of one share in the fund; this is the price that investors pay or receive when they buy or sell shares in the fund.

Investors typically choose to buy bond funds for two reasons: income and diversification. Bond funds tend to pay higher dividends than money market and savings accounts, and they usually pay out dividends more frequently than individual bonds. Bond funds are also considered to be “low risk” investments that can provide stability to a portfolio that is weighted heavily with stock. You should note, however, that bond funds are not risk-free investments — they are still subject to the same credit and interest rate risks as regular bonds. But since the fund’s investments are spread out among many bonds, the overall risk is usually lower. Bond funds are also more liquid investments than individual bonds; shares can be bought and sold much more easily. Like some types of bonds, certain bond funds may be exempt from federal and/or state taxes .

Types of Bond Funds

There are three basic types of bond funds: U.S. government bond funds, municipal bond funds, and corporate bond funds. The returns of these bond funds differ according to the amount of risk inherent in each fund.

US Bond Funds

U.S. government bond funds invest in debt securities that are issued by the United States government and its agencies. These funds are regarded as the safest of the bond funds because the underlying securities are backed by the full faith and credit of the United States government (however, the fund itself is not backed by the government). The funds invest in such debt instruments as Treasury bills, Treasury notes, Treasury bonds, and mortgage-backed securities issued by government lending agencies such as Fannie Mae . Certain U.S. government bond funds, like Treasury funds, are exempt from state and local (but not federal) taxes. The biggest risks involved in investing in these funds are related to fluctuating interest rates and inflation.

Municipal Bond Funds

Municipal bond funds invest in debt securities issued by state and local governments to pay for local public projects, such as bridges, schools, and highways. These bond funds are popular among investors with high incomes because they are exempt from federal taxes and, in some cases, from state taxes as well. As with U.S. government bond funds, the underlying securities in municipal bond funds are backed by the government and thus are considered to have a high credit rating. However, municipalities have been known to declare bankruptcy on occasion, making these funds more risky than their U.S. government counterparts.

Corporate Bond Funds

Corporate bond funds are comprised of bonds issued by corporations. Unlike the securities held by U.S. government and municipal bond funds, the bonds in a corporate bond fund are not backed by any government institution. Thus it is more likely that the underlying bonds could default if the companies that issue them run into financial trouble. Along with the greater risk, however, comes a greater reward — the income paid out by corporate bond funds is typically much greater than that paid by municipal or U.S. government bond funds. Investment-grade corporate bond funds invest only in the most creditworthy of companies; they are considered to be the safest of all corporate bond funds.

Other Types of Bond Funds

Besides the aforementioned bond funds, there are many other types of bond funds. Zero-coupon bond funds invest in zero coupon bonds ; international bond funds invest in bonds issued by foreign governments and corporations; convertible securities funds invest in bonds that may be converted into stock . And finally, if you’re looking to diversify your holdings even more, there are multisector bond funds that invest in all different types of bonds: corporate bonds, municipal bonds, international bonds and so on.

Copyright Fund China 2009.

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