Understanding bond fund types
It's important to understand the difference between government, corporate, high-yield and municipal bond funds.
These funds invest primarily in bonds issued by the U.S. Treasury or federal government agencies, which means you don't have to worry about credit risk. But because of their higher level of safety, their yields and total returns tend to be slightly lower than those of other bond funds.
That's not to say government bonds funds don't fluctuate - they do, right along with interest rates. If you can't tolerate swings of more than a few percentage points, stick to short-term government bond funds.
If moderate fluctuations so don't cause you to break out in a cold sweat, then you can pick up a bit more yield with intermediate government bond funds. If you plan on holding on for several years and can handle broader swings, long-term government bond funds will provide even more yield.
Funds in this category buy the bonds issued by corporations that may range from well-known household names to obscure widget makers most of us have never heard of.
When researching corporate bonds funds, consider the credit quality of the individual bonds they hold (most hold highly rated bonds, AAA to A minus or A3, but some take more risk by adding small doses of high-yielding junk bonds.) Also consider the average maturity of the bonds - the longer the average maturity, the greater the volatility.
Putting the euphemism aside, these are junk bond funds. They invest in debt of fledgling or small firms whose staying power is untested as well as in the bonds of large, well-known companies in weakened financial condition.
The potential for these companies to default on their interest payments is much greater than on higher quality bonds, but since these funds usually hold more than 100 issues, a default here and there won't capsize the fund.
There is more risk, however, and for that, you get higher yields - from 3 to as much as 10 percentage points more than safer bond funds. These funds tend to shine when the economy is on a roll, and suffer when the economy is fading (increasing the chance of default).
Who should buy them: Investors who want to boost their income and total returns and can tolerate losses of 10% or so during periods of economic turbulence.
Tax-exempt bond funds - also known as muni bond funds - invest in the bonds issued by cities, states, and other local government entities. As a result, they generate dividends that are free from federal income taxes.
The income from muni bond funds that invest only in the issues of a single state is also exempt from state and local taxes for resident shareholders. Once you factor in the tax benefits, muni funds often offer better yields than government and corporate funds.