Some investors like to keep bond funds in their portfolios for balance. Others begin eyeing bond funds more appreciatively during a downturn in the stock market because of their reputation for safety. It is important to be aware, however, that bond funds are not inherently safe, and some are riskier than others. There are a variety of bond funds available to satisfy different investing objectives, including government bond funds, municipal bond funds, corporate bond funds and more.

What Is a Bond Fund?

A bond fund is a type of mutual fund or unit trust that invests primarily in bonds or other debt securities. These bonds may have been issued by the U.S. government, municipal governments or corporations.

When you buy into the fund you are pooling your money with that of other investors, which the fund's managers then use to purchase securities according to their performance and the bond fund's charter. You and the other investors then share the gains and losses that the fund generates, in proportion to the amount you invested.

Difference between Bonds and Bond Funds

While some investors assume bonds and bond funds work the same way, this is not the case.

Bonds are fixed-income investments, while bond funds are not. When you buy a bond, you are loaning money to the bond's issuer. In return, you will receive interest payments and the capital will be returned when the bond matures, provided the issuer does not default.

A bond fund, on the other hand, does not promise your capital back, nor are you offered a fixed rate of interest.

U.S. Government Bond Funds

Government bond funds are a good choice for risk-averse investors who want to keep their money safe. This type of fund invests in bonds issued by the U.S. Treasury or other government agencies, which are considered the safest of all securities. Because they are so safe, they tend to offer lower yields than other bonds. Government bond funds tend to rise and fall with interest rates.

Municipal Bond Funds

For those interested in tax savings, municipal bond funds are the way to go. These funds invest in bonds issued by local governments, like states and cities. Dividend income generated by these funds is not subject to federal income taxes. They may even be exempt from state taxes if the fund invests in bonds issued by your state government. Read through the fund's prospectus to learn more about the tax savings it offers.

Corporate Bond Funds

This type of fund invests in corporate bonds, which generally give better returns than government bonds and can offer a good degree of safety. Most corporate bond funds invest only in bonds with good credit quality, those rated AAA to A3 or A-, though some will throw a few riskier bonds into the mix for diversity. It is important to research a fund carefully prior to investing in it, in order to learn the type of securities it buys and whether its objectives match yours.

Other Bond Funds

While government, municipal and corporate bond funds are three of the most common, there are several other categories of funds. Though there are others, junk, convertible, ultra-short and zero-coupon bond funds are three common types,.

• For those who like to take a risk with their investments, high-yield, or junk, bond funds are the way to go. These funds invest in bonds with a higher risk of defaulting, but they offer higher yields than safer bonds.

• Convertible bond funds focus on bonds that can be redeemed for the company's stock.

• For an ultra-short bond fund, fund managers seek out bonds that will mature within a short period of time.

• Zero-coupon bond funds buy bonds that don't offer dividend income and can be purchased for much less than the face value, but are redeemed for the face value at maturity.

Risks

While bonds and bond funds have a reputation for safety, you can still incur losses when investing in these securities. For example, city governments may go bankrupt and companies can go out of business, or choose to pay off the bond early. Refer to the Securities and Exchange Commission Web site at www.sec.gov/answers/bondfunds.htm for additional information about bond fund risks.

Choosing Bond Funds