Basics on Fixed-Income Funds

Fixed-income mutual funds are an excellent diversification tool for investors’ portfolios. And as the name suggests, they can be used for generating income. But what are fixed-income funds?

Commonly called bond funds, fixed-income funds are simply mutual funds that own fixed-income securities such as US Treasuries, corporate bonds, municipal bonds, etc. These fixed-income funds come in many shapes and styles. Let’s start with five basic types of fixed-income funds.

Treasury-Inflation Protected Securities (TIPS) Fixed-Income Funds

TIPS are bonds issued by the US Treasury that pay a coupon on the adjusted principal of the bond. The bond is adjusted on a semi-annual basis with the rate of the Consumer Price Index (a measure of inflation). So, TIPS are said to keep pace with inflation by returning the adjusted principal upon maturity and coupon payments along the way. There are pros and cons of TIPS mutual funds.

Here a few of the best TIPS fixed-income funds:

• Vanguard Inflation-Protected Securities Fund
• T. Rowe Price Inflation Protected Bond Fund
• Fidelity Inflation-Protected Bond Fund

Municipal Fixed-Income Funds

Municipal fixed-income funds hold bonds that are issued by municipalities such as cities and states. Municipal bonds generally receive favorable tax treatment. The interest on most municipal bonds is tax-free at the federal level and is tax-free for investors who buy municipal bonds that are issued within their state of residence. There are also private-activity municipal bonds.

Investors that live in California, Massachusetts, New York, and several other states, have many options to invest in double tax-free municipal bond mutual funds (Federally and state tax-free). Other investors will find national municipal bond mutual funds to be of value.

Generally, except for extreme circumstances, municipal bonds have a lower yield than taxable bonds of similar credit quality, making it necessary to understand tax-equivalent yields.

These are a few of the best municipal fixed-income funds:

• Vanguard Intermediate-Term Tax Exempt
• Fidelity Municipal Income Fund

Investment Grade Corporate Fixed-Income Funds

Investment grade corporate bonds are issued by high-quality corporations in order to raise capital for the corporation. These bonds are typically rated BBB and above by S&P or Baa and above by Moody's. Investment grade corporate fixed-income funds allow investors to gain access to a diversified basket of corporate bonds, reducing risk (credit risk, interest rate risk and reinvestment risk).

Many mutual fund companies offer investment grade corporate fixed-income funds with various durations and maturities. Several Vanguard bond funds are listed below:

• Vanguard Short-Term Investment Grade
• Vanguard Intermediate-Term Investment-Grade
• Vanguard Long-Term Investment-Grade

High-Yield Fixed-Income Funds

High-yield bonds are often referred to as “junk bonds” due to their low credit ratings. These bonds are issued by corporations and are rated below BBB by S&P and/or below Baa by Moody’s. High-yield bonds typically have higher yields than investment grade corporate bonds due to the additional credit risk that is taken by the buyer of the bonds. So, remember, high yield comes with higher yields but higher risk.

A couple of the best high-yield fixed-income funds:

• Vanguard High-Yield Corporate Fund
• Fidelity High Income Fund

International Fixed-Income Funds

Just like it sounds, international bond mutual funds invest in bonds issued by foreign entities. Investors can take advantage of a depreciating US dollar by purchasing an unhedged international bond mutual fund. All else being equal (bond yield and bond price), if you own a foreign bond and the US dollar loses ground to that foreign bond’s currency, you will gain/lose based on the foreign currency’s appreciation/depreciation. There are also bond mutual funds that practice currency hedging - in order to avoid the inherent volatility of currency prices.

Keep in mind: Before you invest in a fixed-income fund there are a few items to consider. As a first step, consider reading "Before You Invest in a Bond Mutual Fund."