Bond funds offer investors an easy way to tap into the bond market without having to tap too deeply into their savings.
Bonds are debt that governments and corporations take on. People who buy the bonds essentially lend them the money, which they get back in return plus interest, providing what is generally a fixed-income return. But bonds can be expensive for investors, with the minimum investment often $5,000 or more. The benefit of bond funds is that the minimums for investing are typically lower, and since they invest in a number of offerings, investors get greater diversification.
Bond funds differ from bonds in other ways as well. Unlike individual bonds, bond funds don't have a fixed maturity date, nor do they have a guaranteed interest rate. Also, unlike bonds, bond funds don't guarantee to return your initial investment.
As with stock funds, bond funds come in all shapes, sizes, investment criteria and risk levels. Some bond funds invest in very safe government bonds that provide steady returns with little risk. On the other side of the spectrum, some bond funds invest in junk, or high-yield, debt from companies. Junk bonds carry a higher risk that the company will default on its loan payments. Because of these risks, junk bonds carry substantially higher interest rates, meaning the potential for higher returns, or high yields.
For investors looking to minimize their tax bite, there are tax-free bond funds, which invest in municipal bonds (debt offerings from state and local municipalities) whose distributions aren't subject to federal taxes nor taxes in the states and localities that issue the bonds. If this sounds good to you, look for a tax-free bond fund that focuses on your municipality and state.
Bonds, Bonds, Bonds
There's a great variety of bond funds out there, from the stodgy to the high risk. Before jumping into bond funds, check out this primer on the sector from TheStreet.com's archives
Choosing a Bond Fund, Part I
Choosing a Bond Fund, Part II
Bonds or Bond Funds: An Age-Old Dilemma
Bonds Can Corral Your Risk