Mutual funds enable diversification of investments over broad portfolios of financial securities that are managed professionally. This would otherwise be prohibitively expensive for small investors to do. Fund managers pool large numbers of small investments to create mutual funds. They buy shares for a fee directly from mutual funds, and only the fund can redeem the shares.
Mutual funds are categorized according to the financial security types they buy. Bond funds refer to mutual funds that buy fixed income or debt securities. Usually these funds are deemed safer than other types of funds such as stock or equity funds. But some risk is involved. The issuers of bonds, unless they are U.S. government bonds, may default. Interest rates may rise, and this automatically decreases the value of the bonds in the funds. Borrowers can also prepay bonds when bond prices increase. This means that investors may have to buy higher priced, lower yielding bonds. And bond funds usually have a lower return than riskier stock funds.
Government bond funds include bonds issued at the federal, state and municipal levels. Government agencies also can issue bonds. For example, Fannie Mae and Freddie Mac issue mortgage-backed securities that, while not explicitly backed by the U.S. government, are assumed to be so backed. Usually called Treasury bonds, U.S. federal bonds can be short, medium or long term, and the public perceives little risk with these instruments. State and municipal bonds are also considered safe, but some municipalities have been known to default. Municipal bonds usually are exempt from federal taxes and even, depending on their characteristics, local taxes. Government bond funds are not immune from interest rate risk.
Sometimes, when corporations need to finance investment projects and cover expenses, they issue bonds and these make up corporate bond funds. The risk associated with these funds varies according to the creditworthiness of the issuing corporations. They can go from investment grade all the way to junk bond funds, with returns accordingly going from low to high. Investment-grade funds invest in high quality bonds. Since corporate bond funds are not backed by the federal government, they may lose money even if they contain investment-grade bonds. Corporate bond funds are also susceptible to interest and prepayment risk. They are usually less risky overall than stock funds, but they typically generate smaller returns. They are not exempt from taxes.
Bond funds can be made up of bonds issued internationally, whether these are by foreign governments or foreign corporations. Usually, a distinction is made by distinguishing between bonds that come either from developed or developing countries, also called emerging markets. Bonds that come from developed countries are usually safer than those from developing country governments or corporations. Bonds from developed countries normally are safer and have lower returns than bonds from developing countries, which tend to be riskier. Investors also can mix a variety of bond types to create a diverse portfolio. They can mix safer and lower yielding government bonds with riskier and higher yielding corporate bonds. They also can combine U.S. bonds with bonds issued by foreign entities.