Bond funds are a common type of mutual fund, which deal mainly in debt securities such as bonds. The point of a mutual fund is that it is a method of collective investment where a fund manager uses money that is pooled from many investors to trade in stocks, bonds, and securities. He then collects and passes on any income obtained through dividends or interest. Bond funds are the type of mutual fund that involves bonds and these can be classified as government, mortgage, corporate or municipal bonds. Bond funds typically pay better than individual bonds do. But beware because they can come in high risk, high potential yield, forms, as well as low-risk, low potential yield forms.
Bond funds can vary according to the level of risk involved, the type of entity issuing the bond such as the government, for example, or the maturity of the bonds. The fund manager will continually adjust the investment portfolio to achieve the stated aims of the fund, whatever the strategy may be. Government, or treasury bonds, are considered the safest type of bond investment because they are backed up by the government. On the downside they typically have a low yield.
Mortgage bonds are loans that are guaranteed or issued by government-backed agencies. Examples of such agencies are the now infamous Fannie Mae and Freddie Mac. Corporate bonds are those that are issued by corporations who will pay out, if they can, when the bonds mature. The high-yield, or junk bonds, that you may be interested in involve the investment in corporate bonds at the riskier end of the spectrum. Although this is a higher risk strategy there is a potentially higher pay out if you are prepared to accept that risk.
A more conservative option to go for involves what are called municipal bond funds. These are considered less of a risk and they have tax advantages, such as being exempt from national income tax, but they won’t yield as much as some other types of bond fund. Municipal bonds are issued by agencies and government at the state and local level.
Bond funds provide a number of advantages over individual bonds. They involve dedicated management of the portfolio by a fund manager. By investing in multiple individual bonds they reduce the effects of individual underperformance. Any income made can automatically be reinvested in order to continue generating more cash. There is also a liquidity advantage in that you can sell at any time rather than waiting for maturity.