For safety of capital an investor will choose the best bond funds. A slightly better return, over the long term, gives much more gain and much better preservation of capital. Bond funds have their assets mostly in bonds or other types of debt securities. A bond fund may concentrate its investments in a particular type of bond or debt security—such as:

• government bonds (safest of all are U.S. government bonds)
• municipal bonds (tax advantage)
• corporate bonds (somewhat higher rate of interest paid)
• convertible bonds
• mortgage-backed securities
• zero-coupon bonds

or a mixture of types. The securities that bond funds hold will vary in terms of risk, return, duration, volatility and other features.

You can lose money investing in a bond fund. Bonds and bond funds have some risk. Like any investment. The investment risks include credit risk, interest rate risk, and prepayment risk. A bond fund’s prospectus should disclose these and any other risks. Before investing in a bond fund, you should carefully read all of the fund’s available information, including its prospectus and most recent shareholder report.

Credit risk

Credit risk is the risk that the issuers of the bonds owned by a fund may default (fail to pay the debt that they owe on the bonds that they have issued). This risk may be minimal for funds that invest in U.S. Government bonds. However, long term U.S. Government bonds have interest rate risk, as explained in the next section.

Interest rate risk

Interest rate risk is the risk that the market value of the bonds owned by a fund will fluctuate as interest rates go up and down. For example, when interest rates go up, the market value of bonds owned by a fund generally will go down. Nearly all bond funds are subject to this type of risk, but funds holding bonds with longer maturities are more subject to this risk than funds holding bonds with shorter maturities. Because of this type of risk, you can lose money in a bond fund, including those that invest only in insured bonds or U.S. Government bonds. If inflation increases, and interest rates increase also, long term bond funds will lose value. So you will have to choose between short term low interest with lower risk versus long term high interest with greater risk.

As an example of how the market prices the interest rate risk, consider two index funds by Vanguard. The Vanguard Short-Term Bond Index Fund Investor Shares (VBISX) has average maturity of 2.8 years and an SEC yield of 1.53%. The Vanguard Long-Term Bond Index Fund (VBLTX) has average maturity of 22.6 years and an SEC yield of 5.18%. (Both yields as of 4/22/10.) The short term fund has more than 5 times as much money invested in it as the long term fund.

Related to the interest rate risk is the inflation risk. As trillion dollar deficits add up, the dollar will go down in value. For the most conservative approach, and to avoid the financial risk caused by the political popularity of deficit spending, you may want to visit the most conservative investing page.

Prepayment risk

Prepayment risk is the risk that the issuers of the bonds owned by a fund will prepay them at a time when interest rates have declined. Because interest rates have declined, the fund may have to reinvest the proceeds in bonds with lower interest rates, which can reduce the fund’s return. (Not all bonds, however, can be prepaid.)

Tax advantages of a municipal bond fund

Some bond funds invest in municipal bonds that pay interest which is exempt from federal income taxes. In addition, interest on the bonds of some states are exempt from taxation by that state. Not all of the income that you receive from a municipal bond fund, however, will necessarily be exempt from federal or state income tax. The fund’s prospectus will describe any of its tax-exempt features.

Ultra-short bond fund

Ultra-short bond funds are mutual funds that generally invest in fixed income securities with extremely short maturities, or time periods in which they become due for payment. Like other bond funds, ultra-short bond funds may invest in a wide range of securities, including corporate debt, government securities, mortgage-backed securities and other asset-backed securities.

Some investors don’t realize that there are material differences between ultra-short bond funds and other investments with relatively low risks, such as money market funds and certificates of deposit. Specifically, ultra-short bond funds tend to have higher risks than money market funds and certificates of deposit (CDs).

To learn more about ultra-short bond funds, including some of the material differences between these funds and other investments, you should read Ultra-Short Bond Funds.

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