Unless you have some big bucks to throw at the market, building a diversified portfolio of bonds could be financially prohibitive. But a bond mutual fund gives a smaller investor an opportunity to become a shareholder in a diversified portfolio of bonds. You can invest in bond funds with as little as $500 to $1000 and get instant diversification and professional management.
Bond funds hold dozens of different bonds with different maturity dates, providing instant diversification for fund shareholders. Bond funds first became popular in 1970s, when investors began opting for managed portfolios of bonds rather than individual bonds.
An offshoot of the traditional bond fund is the high-yield bond funds or "junk bond funds." Safety is a major concern with individual junk bonds, so the diversification that a mutual fund offers makes it a much safer investment. Even if one or two of the bonds in the fund default, the ultimate impact on shareholders is minimal. But if you own an individual bond that defaults, that can be a major shock to your bottom line.
Over the years, the universe of bond funds has exploded. Now they come in many different forms, including:
- Corporate bond funds
- Junk bond funds
- Municipal bond funds
- Mortgage-backed bond funds
- Global bond funds
- Broad bond funds that invest in several types of bonds
- Money market funds
Whatever the type of bond that interest you, there's probable a bond fund that specializes in it.
Bond funds are appropriate for income-oriented and conservative investors who want to earn a steady income with a minimum of risk. They might also be suitable for aggressive stock-oriented investors looking for diversification.
Aggressive investors looking for income might prefer high-yield bond funds over other types of bond funds because of the better returns. Conservative investors might want a combination of of corporate, government, global, mortgage-backed, and high-yield funds. Affluent investors looking for additional income prefer municipal bond funds because of the tax savings.
However, unless you need the income, you should use bond funds primarily for your tax-deferred retirement fund, with one exception - tax-exempt municipal bond funds. There is no point in putting a tax-exempt fund into a tax-deferred account.
