There are three basic types of bond funds: U.S. government bond funds, municipal bond funds, and corporate bond funds, in each of which, the returns could vary.
US Bond Funds
U.S. government bond funds invest in debt securities that are issued by the United States government and its agencies/ states. These funds are regarded as the safest of the bond funds because the underlying securities are backed by the full faith and credit of the United States government/ states. The bond funds invest in such debt instruments as Treasury bills, Treasury notes, Treasury bonds, and mortgage-backed securities issued by government lending agencies. The risks involved in investing in these funds are related to fluctuating interest rates and inflation, which varies from time to time, and are governed by the Fed.
Municipal Bond Funds
Municipal bond funds invest in debt securities issued by state and local governments to pay for local public projects, such as bridges, schools, and highways or other infrastructure projects. Investors with high incomes prefer these because they are exempt from federal taxes and, in some cases, from state taxes as well. The underlying securities in municipal bond funds are backed by the government and thus are considered to have a high credit rating. However, over the past few years, municipalities have shown a track record to declare bankruptcy on some occasions, making these funds more vulnerable.
Corporate Bond Funds
Corporate bond funds comprise of bonds issued by corporations. However, these bonds in a corporate bond fund are not backed by any government institution. Thus it is more likely that the underlying bonds could default if the companies that issue them run into financial trouble, as has happened in the last financial slowdown of 2007-08. However, a greater risk leaves room for a greater return than government backed funds, as the income paid out by corporate bond funds is higher than that paid by municipal or U.S. government bond funds. Investment-grade corporate bond funds invest only in the most creditworthy of companies and are considered to be the most safe corporate bond funds.
Other Bond Funds
Besides the above bond funds, there are some other variations of bond funds. These include the Zero-coupon bond funds, which invest in zero coupon bonds, International bond funds, which invest in bonds issued by foreign governments and corporations and convertible securities funds which invest in bonds that may be converted into stock at a later date. Apart from these, there are multi-sector bond funds that invest in all different types of bonds, including corporate bonds, municipal bonds, international bonds etc. Such bond funds are a good addition to the portfolio for someone seeking a high degree of diversification in portfolio and averse to risk taking in one kind of bonds.
Bond Manager – Making the choice
A typical bond manager chooses his line of action amongst the variations available on selection of kind of bond funds amongst the above choices available, based on his intelligence to forecast the benchmark interest rates decided by Fed in a period of three to six months ahead. The same typically depends upon the status of economy of the country, and the fluctuation of currency, based on which, the bond prices tend to move in the market. It is an important step for the buyer of bond mutual funds, to make the right selection of the ideal one, who may have a proven track record in past.