Mutual Fund Talk

Different Types of Bond Funds

Do you know there are more than one types of fixed income mutual funds?

Term Funds

All bonds are structured so you get paid your principal after a set amount of time. They're either short, intermediate or long term, depending on the number of years until they mature. Bond funds are the same way. A fund like Scudder Short-Term Bond is typical of its class, buying a mixture of corporate and government bonds with durations between one and 3.5 years. Intermediate funds like Stein Roe Intermediate range between 3.5 and 10 years, while Vanguard Long-Term Corporate only buys bonds with durations greater than six years.

Generally speaking, the longer the duration, the higher the risk and reward. Why? Because the longer you hold a bond before it matures, the greater the chance its value could be adversely affected by changes in interest rates. As a result, whatever company or government issued the bond has to promise a higher yield upfront.

Municipal Bond Funds

Muni-bond funds invest in bonds issued by state municipalities. Some funds, like Eaton Vance National Municipal, invest in bonds offered throughout the country. Others, like Dreyfus New York Tax-Exempt Intermediate, invest in one state only. Tax breaks are the big draw of muni-bond funds. If you own a national fund, you are exempt from federal income taxes on any income you receive from the fund. If you live in the state specified in a state-specific fund, you are exempt from state and federal taxes. However, your lower taxes generally come with lower returns. Only investors in high tax brackets should buy these funds.

High-Yield Bond Funds

Bond funds invest in different grades of corporate bonds. High-yield, or "junk-bond," funds are the most well-known of the bunch, because they offer the highest rates. Unfortunately, since these funds invest in low-grade corporate issues, they also entail the greatest risk. Companies with credit ratings of BBB or less are the most likely to default on their coupon payments. In another words, although the income may be high on a fund like Fidelity High Income, it's not guaranteed. Only the most risk-tolerant investors need apply.