Bond Funds

A bond fund holds many different bonds to ensure the fund spreads its risk among many bonds. Bond funds come in many different flavors: short to long maturities, low to high credit risk, treasuries, inflation protected, corporate, municipal, zero coupon, foreign and more. Some funds are actively managed and buy and sell bonds for capital gains. Others are passively managed like index funds or exchange traded funds.

There are more than 2000 bond funds which you may buy from mutual fund companies and brokers. The minimum initial purchase is usually from $1,000 to $10,000 for regular accounts and somewhat lower for retirement accounts. Bond funds charge annual fees and some have initial sales charges when you buy them. Avoid funds with high fees.

Most funds distribute monthly interest payments and some funds let you reinvest the interest payments to purchase additional shares of the the fund. Most funds let you set up an automatic investment schedule so you may dollar-cost averaging you purchases.

Bond funds do not mature on a specified date like individual bonds. So you are not guaranteed that you will recoup your initial investment. In fact bond funds are sensitive to changes in interest rates so the price of bond funds fluctuates. If interest rates increase, the price of the fund falls and vice versa. So you should buy bond funds when interest rates are falling and avoid them when interest rates are rising. If rates rise quickly, negative price changes will offset interest payments and you could lose money. Even though bond funds are thought to be conservative investments, if you pay too much for a fund you will probably lose money.

Short-term Bond Funds

Short-term bond funds hold bonds with maturities of one to five years and are the least volatile in price. Some funds hold high risk bonds and others hold low risk bonds.

Example: Vanguard Short-Term Bond Index (VBISX) holds US Treasury Notes and some short-term corporate bonds.

Intermediate-term Bond Funds

Intermediate-term bond hold bonds with maturities of three to 10 years. These funds have yields between the yields of the short-term and long-term funds.

Example: Vanguard Intermediate-Term U.S. Treasury (VFITX) major holdings are U.S. Treasury notes and some longer-term bonds.

Long-term Bond Funds

Long-term bond funds hold bonds with maturities greater than 10 years. Long-term funds have the highest yields but they are subject to the greatest interest rate risk so their prices are more volatile than short and intermediate-term funds.

Example: Vanguard Long-Term U.S. Treasury (VUSTX) holds long-term U.S. treasuries.

Municipal Bond Funds

Some municipal bond funds hold bonds from many states while other funds concentrate on a single state. All municipal bonds are exempt from federal taxes and funds holding only municipals issued for a particular state are exempt from state taxes for residents of that state. Because of the tax-exempt status of municipal bond funds, their yields are lower than their treasury and corporate counterparts. People in high tax brackets can take advantage of the tax-exempt status of municipal bonds.

Example: Vanguard High-Yield Tax-Exempt (VWAHX) holds investment-grade municipal securities.

High-Yield Bond Funds

High-yield bond funds hold high-yield, riskier bonds that pay relatively high coupons. High-yield funds spread the credit risk among many high-yield bonds.

The price fluctuations of high-yield bond funds tends to be high so you want to buy the fund when prices are low.

Example: Vanguard High-Yield Corporate (VWEHX) holds corporate bonds and some risk free U.S. treasuries.

Inflation Protected (TIPS)

Inflation protected funds hold TIPS which are adjusted for inflation to help preserve the purchasing power of your investment.

Example: Vanguard Inflation-Protected Securities (VIPSX) major holdings are inflation-protected U.S. government securities.

Index Bond Funds

Index bond funds hold basket of funds that track major bond indices. The bonds in these funds are not regularly bought and sold so their annual fees are lower than fees charged for actively managed funds. Index bond funds are sold by mutual fund companies.

Example: Vanguard Total Bond Market Index (VBMFX) tracks the Lehman Brothers Aggregate Bond Index.

Bond Exchange Traded Funds (ETFs)

Bond exchange traded funds (ETFs) hold baskets of bonds that track established bond indices. The bond ETFs trade on a major stock exchange and you buy and sell them through a broker and pay commissions for each transaction. But you do not pay annual fees like you do with a bond fund.

Popular bond ETFs includes the family of iShares Lehman that include baskets of U.S. Treasuries, corporate bonds and inflation protected bonds. For example, the iShares Lehman TIPS Bond Fund (TIP) invests in a basket of Treasury Inflation Protected Securities.

See the Yahoo! Finance Exchange-Traded Funds (ETF) Center for more information about ETFs.

More Information

For more information about bond funds see Bonds and Bond Funds and A Guide to Bond Mutual Funds.

Updated August 20, 2007.