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TO UNDERSTAND how bond funds work, you should really visit our Bonds section. But we'll touch on
them here. Bond funds are designed to give your portfolio its recommended dose of fixed-income
investments so you don't have to go through the hassle of buying bonds yourself. These, too, come in
various types.
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.
YAHOO! FINANCE TIP
Use the Yahoo! Finance mutual fund screener to find the right bond funds for you.
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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.
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