From Dustin Woodard,
Your Guide to Mutual Funds.
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Bond Fund Basics

To understand bond funds, or fixed income funds we need to first understand what bonds are. Bonds are simply a loan, but in the form of a security. "Who’s the borrower?" you may ask. In this case, it is usually the government (including state and local governments) or corporations like IBM or General Motors. By issuing bonds, these borrowers can raise money from the public.

Bonds are promises to pay back the original amount (the principal) plus interest--similar to mortgage or car loans, where you were the borrower. Bonds are considered less risky than stocks, but do carry their own risks (namely inflation, credit and prepayment risks).

A "bond fund" or "income fund" describes a mutual fund that invests primarily in bonds or other debt securities. Bond funds are often used as a way to balance out a portfolio because the bond market behaves differently from the stock market. By diversifying between the two, the levels of risk you take goes down significantly. Bond funds are also used to create regular income--something that is important when you are in or close to retirement.

Bonds vs. Bond Funds

Bond funds are very popular because they are convenient and provide diversification. Bonds can be complex, so having a professional fund manager manage the portfolio and pay you on a regular basis (usually monthly) is very attractive. Bond funds can also have efficiencies and capabilities that would be nearly impossible for an individual to mimic (expect, maybe, a very wealthy individual). People also enjoy bond funds because they can be automatically reinvested if you want and some even carry check writing privileges.

What Kinds of Bond Funds Are There?

As mentioned in Different Kinds of Mutual Funds, bond funds are often categorized by as:

• Municipal Bond Funds -uses tax-exempt bonds issued by state and local governments (these funds are non-taxable).
• Corporate Bond Funds -uses the debt obligations of U.S. corporations.
• Mortgage-Backed Securities Funds - uses securities representing residential mortgages.
• U.S. Government Bond Funds -uses U.S. treasury or government securities.

Another way to categorize bond funds is by maturity date:

• Short-term Bond Funds –usually means the holdings have up to two years left to maturity. This includes bills, CDs, and commercial paper.
• Intermediate-term Bond Funds –usually means the holdings have between two years to ten years until maturity. This includes notes,
• Long-term Bond Funds –usually means the holdings have over ten years left to maturity.

Best Bond Uses

Portfolio Risk Reduction: As mentioned earlier, bonds are often a great way to balance out your stock or stock fund holdings.

Emergency Money: Short-term funds with check writing privileges can provide higher returns than money market funds.

Monthly Income: Bond funds often generate monthly income, which is very attractive to those in retirement. Similar to CDs, bond funds are great for the risk-averse, but don’t require you to be locked in like CDs.