Encyclopedia of Investment Terminology

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Bond Funds

The terms Bond Fund and Income Fund are used to describe a type of investment company (mutual fund, closed-end fund, or Unit Investment Trust (UIT)) that invests primarily in bonds or other types of debt securities. Depending on its investment objectives and policies, a bond fund may concentrate its investments in a particular type of bond or debt securityósuch as government bonds, municipal bonds, corporate bonds, convertible bonds, mortgage-backed securities, zero-coupon bondsóor a mixture of types. The securities that bond funds hold will vary in terms of risk, return, duration, volatility, and other features.

A common misconception among some investors is that bonds and bond funds have little or no risk. Like any investment, bond funds are subject to a number of investment risks including:

"Credit risk" This is the risk that the issuers of the bonds owned by a fund may default (fail to pay the debt that they owe on the bonds that they have issued). This risk may be minimal for funds that invest in insured or U.S. Government bonds.

"Prepayment risk" This is the risk that the issuers of the bonds owned by a fund will prepay them at a time when interest rates have declined. Because interest rates have declined, the fund may have to reinvest the proceeds in bonds with lower interest rates, which can reduce the fundís return. (Not all bonds, however, can be prepaid.)

"Interest rate risk" This is the risk that the market value of the bonds owned by a fund will fluctuate as interest rates go up and down. Nearly all bond funds are subject to this type of risk, but funds holding bonds with longer maturities are more subject to this risk than funds holding bonds with shorter maturities. Because of this type of risk, you can lose money in a bond fund, including those that invest only in insured bonds or government bonds.

A bond fundís prospectus should disclose these and any other risks.

Many bond funds invest in tax-exempt municipal bonds of a particular state. Depending upon your state of residence, the bonds of your state may be exempt from state as well as federal income tax. Not all of the income that you receive from a municipal bond fund, however, will necessarily be exempt from federal and state income tax. The fundís prospectus will describe any of its tax-exempt features.

Before investing in a bond fund, you should carefully read all of the fundís available information, including its prospectus and most recent shareholder report.

Much of the above information is courtesy of the SEC.


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