Types

• Bond funds invest in a particular type of bond or a specified combination of bonds. These can include federal, state and municipal government bonds, corporate bonds, convertible bonds and securities backed by debt-like mortgages. A variety of these are sometimes mixed together to accomplish particular return or risk goals.
  
  

Benefits

• Some bond funds are tax exempt. Many municipal bonds are free of taxes for a particular state. Some of them are also exempt from federal taxes. This is an additional incentive to invest in bond funds because lower taxes contribute to the bottom line. Some bond funds are tax exempt on some types income but not others. The bond fund managers reveal these details in the fund prospectus and the year end tax statement.
  
  

Warning

• Bond funds are often seen as safer investments than stock funds. While this may be true at times, there are significant risks to bond fund investing. Bonds are essentially a promise to repay a debt. If the people who borrowed against the bonds don't pay the money back, the fund will default. If the debt is paid back early, the bond fund may have to find other investments that don't pay as high an interest rate. This will lower returns. This value of a bond fund can also change with interest rates. Longer maturity bonds are especially susceptible to this. A fall in value can decrease the principal of your investment if you decide to sell your bond fund.
  
  

Misconceptions

• It was once widely believed that bond funds containing mortgage loans were extremely safe and provided consistently good returns. The mortgage crisis of 2008 proved that wrong. Mortgage loans guaranteed by the Federal National Mortgage Association, known as Fannie Mae, and the Federal Home Loan Mortgage Corporation, known as Freddie Mac, defaulted in huge numbers threatening the collapse of the agencies. In September 2008, the Federal Housing Finance Agency seized control of Fannie Mae and Freddie Mac to prevent that. However, investors lost a great deal of money in bond funds that were believed to be safe.
  
  

Considerations

• Bonds funds often focus on a particular quality of bonds. There are several companies that grade bonds on their reliability and credit worthiness. They are assigned letter grades. AAA is considered the highest rating. It indicates that the bond is most likely to be repaid in full and on time. Bonds with a C rating are considered "junk bonds" and quite likely to default. Many bond funds try to reassure investors by promising to only invest in AA bonds or higher. Treasury bonds are backed by the United States government and are considered the safest bonds. They have no rating.