Fixed Income Focus: Bond Fund Basics

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Even during periods when equities are top market performers, bonds may still have a place in your portfolio. As a complement to the more volatile nature of stock funds, fixed-income funds may have the potential to generate a steady stream of income and add stability to a portfolio.

How Bond Funds Work

Bond funds are professionally managed pools of individual bonds. Depending on the fund's investment objective, its manager will buy and sell individual bonds with the goal of producing the best possible returns and generate interest income.

Like individual bonds, a bond fund's value generally moves in the opposite direction of interest rates and carries a variety of risk and reward characteristics. For example, funds that hold bonds with shorter maturities typically have lower risk profiles and lower return expectations than those with longer maturities.

Here is an outline of the most common types of bond funds:

  • Government/Treasury bond funds are made up of bonds backed by the full faith and credit of the U.S. government and typically have lower risk levels and lower returns. Government bond fund returns may fluctuate in accordance with rising interest rates and economic conditions.
  • Tax-Exempt municipal bond funds are made up of bonds issued by local municipalities, such as states, cities, and towns. The interest these bonds earn is generally exempt from federal taxes and, in some cases, state and local taxes; however, income derived from such funds may be subject to the federal alternative minimum tax.

As a result, they have the potential to offer higher after-tax returns for investors in higher tax brackets. Generally, municipal bond funds are affected by interest rate and market risk and fall somewhere in the middle of the risk/return spectrum.

  • Corporate bond funds are made up of bonds issued by corporations. Depending on the issuer, credit ratings can vary considerably, resulting in higher levels of risk and potentially higher returns.

Diversify With Bond Funds

Whether you're looking to reduce risk in an equity-heavy portfolio or generate a stream of income, you may want to consider diversifying your portfolio with bond funds. (Diversification does not guarantee a profit or protect against loss.) Consult a qualified financial advisor for more information on how to construct a fixed-income portfolio that suits your needs.

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