Bond Funds: a conservative risk

A bond is a debt security—like an IOU— that represents a loan an investor makes to a company, municipality or government agency. Bond investments provide income through regular interest payments to bond owners. They also provide the potential for capital appreciation because bond values fluctuate in response to changes in interest rates and economic conditions. Due to the variability of interest rates, bond values will rise as interest rates drop and will fall as interest rates increase.

There are three major types of bonds:

1. U.S. and foreign government bonds, including mortgage-backed securities
2. U.S. and foreign corporate bonds, including high yield bonds
3. National and state tax-exempt municipal bonds

It’s possible to buy an individual bond, but many people prefer to own bond mutual funds instead. They are more affordable, offer better diversification and usually pay income more frequently. Professionally managed mutual funds also can help protect investors from the risks associated with bond investing, namely credit risk and market risk. Credit risk is the possibility that an issuer may not be able to pay interest or repay its debt. Market risk is the possibility that an investor could lose money by selling a bond when prices are low.

Taxable vs. tax-free bonds

Carefully evaluate your investments from the starting line to the finish line. For example, though tax-free bonds often have lower yields than taxable bonds, they can provide higher net income for some investors. Tax-exempt income can give you tax relief now. Tax-free mutual funds pay investors monthly income that is exempt from federal and in some cases, state and local income taxes. That’s because they invest in municipal bonds, which are issued by governments and towns to fund projects in the public interest, such as schools, roads or water systems. The interest paid on these bonds is free from taxation, and that tax-free income is passed along to fund shareholders in the form of monthly tax-exempt distributions.

While the yields on tax-exempt funds are often lower than those of comparable taxable investments, they can actually result in greater net income after taxes for individuals in a high tax bracket.