What it is:
How it works/Example:
Bond funds come in many shapes and sizes. Some of the major bond-fund categories are:
- U.S. Treasury bond funds
- Municipal bond funds
- Mortgage-backed security funds
- Corporate bond funds (within this category are several subcategories based on target maturities, credit rating, industry, etc.)
- International bond funds
- Mixed (where the fund manager invests in a variety of different bond categories)
It's important to note that bond funds are composed of bonds, but they don't always behave like bonds.
For example, bond funds do not mature like individual bonds do. Instead, fund managers buy and sell bonds of differing maturities, which produces constantly changing trading profits, losses, and yields. Although a bond fund's investments do mature, the fund's investors typically don't get their original investments back until they sell their shares (and even then there is no guarantee the fund's share price won't be below the investor's purchase price).
Most investors agree that it is usually easier and less expensive to invest in bond funds than to choose each and every bond in a portfolio. And in addition to the convenience of monthly payments, a bond fund's instant diversification often means lower risk. Bond funds also are a way to avoid the often higher transaction costs and lower liquidity associated with trading individual bonds -- it's often easier to sell bond fund shares than to sell a particular bond, especially if that bond has unusual characteristics or a low credit rating.
Why it matters:
Bond funds offer many tailored choices that go way beyond simple time horizon. For example, target maturity funds are great for investors who need a certain amount of money for a specific purpose at a specific point in the future (such as college tuition). Municipal bond funds can be helpful income investments for investors in especially high tax brackets. International bond funds offer more return and risk potential from their investments in bonds issued by foreign governments or foreign companies in a variety of markets, industries, and currencies.
Even higher on the risk spectrum are high-yield bond funds, which invest in corporate bonds rated below BBB and tend to be more sensitive to changes in their issuers' financial outlooks than to changes in interest rates (they subsequently can actually offer investors a hedge against interest rate risk).