What are bond funds?

Bond mutual funds, also known as debt funds offer opportunities for many investors to add a source of current income to their portfolio. They also tend to have less risk than a stock fund. This makes them a popular choice for conservative investors, people looking for immediate income and people who are looking to add some diversification to a portfolio.

What is a bond?

A bond is a type of loan. The borrower, usually the federal government, a state or municipal government, or a major corporation, sells the bond in exchange for cash. It agrees to pay interest on a regular basis, usually twice a year, and then repay the amount borrowed (also called the principal or the face value) when the bond matures. The amount of interest is typically set as a percentage of the face value and usually does not change. This is why bonds are often called fixed-income securities.

Regular income is the key advantage of owning bonds. Many retired people use those payments to help fund their lifestyle; people who don't want to spend the income now can reinvest the money in their accounts.

Bond risks

As long as the bond issuer is in the financial position to repay the loan, the bond holder will receive the principal back when the loan matures. If an issuer can't pay back the loan, the bond owner will lose the principal. If the issuer goes bankrupt, though, the bonds will have to be repaid before the stockholders receive anything. That's the main reason that bonds have less risk than stocks.

It is also important to understand that the market value of the bond may fluctuate up or down until maturity because of changes in interest rates. An investor buying the bond in the open market cares about the going rates now, not what you received when you bought the bond. If rates go up, the bond's price will go down; if rates go down, the bond's price will go up.

What is a bond fund?

A bond fund is a mutual fund that invests, for the most part, in bonds, including municipal, government, corporate and convertible bonds. These funds may also invest in mortgage-backed securities.

Some are managed to pay a high income, others to maintain the principal value. Still others are managed to get the best possible combination of income and principal, known as total return. Someone looking for a regular income check might care more about the bond's ratio of income to principal, known as its yield. An investor looking for diversification benefits would probably care more about total return than about income.

Investors who are willing to take more risk than they would with a money market fund or a bank account, and are interested in generating income, may want to consider bond funds. Although they fluctuate with interest rates and may lose value, they tend to serve as a more stable piece of a diversified portfolio.

Types of bond funds

Some specific types of bond mutual funds include:

• Investment-grade. These bonds are believed to carry a lower credit risk of default and receive higher ratings by major credit rating agencies. They include bonds issued by the U.S. Treasury, other government agencies and some corporations. Many mortgage-backed securities are also rated with the investment grade classification.
• High-yield bonds. These funds, sometimes referred to as "junk bonds" are corporate bonds that are rated below investment-grade bonds and tend to be riskier. However, high-yield bonds pay higher interest rates and typically provide income and total returns higher than investment-grade bond funds.
• Municipal bond funds. These are issued by municipalities such as cities and states. Generally, municipal bonds have a lower yield than taxable bonds of similar credit quality. These may appeal to investors because even though they may offer lower yields, the interest and income generated are sometimes free from federal taxes.
• International & global. These bond funds are issued by non-domestic governments and corporations and invest in a range of taxable bonds, which may provide portfolio diversification. Generally, international bond funds are subject to higher risk and regulatory requirements.
• Multisector. These funds invest across a range of taxable bonds. A multisector fund may hold high-yield, Treasury, corporate and foreign bonds. The portfolios vary by maturity, issuer, credit quality and average duration. These bonds may be a good opportunity for investors to increase their income potential by tapping into a broad range of exposures across sectors.