Understanding Bond Funds
By: Source: AARP.org Date Posted: 2005-03-20 12:09:08
Bond funds make loans to companies or governments. The income that investors receive from corporate bond funds is usually subject to federal and state income tax. Income from government bond funds is usually tax-free.
What You Should Know
Taxable Bond Funds
As the name implies, you must pay taxes on the income you receive from taxable bond funds. Here are some of the basic types of taxable bond funds:
- U.S. Government Funds: These funds must invest at least 65 percent of their assets in bonds that are issued and backed by the U.S. government.
- Mortgage-Backed Securities Funds: These funds invest in securities issued by the Government National Mortgage Association. This is a federal corporation that buys mortgages from lenders and then resells those mortgages to investors. The federal government backs these mortgages. Therefore, there is little risk of losing your money if a borrower defaults. You do take the risk that borrowers will prepay their mortgages when interest rates fall. This prepayment will reduce your income from the investment.
- Corporate Bond Funds: These funds buy "investment-grade" corporate bonds. These bonds are rated BBB (lower-medium-grade) or higher by a rating agency. High-quality funds usually stick with bonds that are rated A (upper-medium-grade) or better.
- High-Yield Corporate Bond Funds: These funds invest in what has become known as "junk bonds" or bonds that are rated with less than a BBB rating. These bonds can yield high returns, but they are risky.
- Foreign Bond Funds: These funds lend money to companies and governments outside the United States. These funds try to profit from changes in the value of foreign currencies. If the dollar falls against the foreign currency, the fund does well. If the dollar appreciates, the fund loses money. Because currency movements are hard to predict, these funds are risky.
- Flexible Bond Funds: They own a variety of different bond types. Their holdings could include corporate bonds of various grades, mortgage-backed securities, U.S. Treasuries, and foreign bonds.
Tax-Exempt Bond Funds
The interest income you receive from investing in municipal bond funds is generally free from federal income tax. These funds also could be free from state taxes if you live in the state where the bond is issued. There are several types of municipal bonds:
- National Municipal Bond Funds: These funds invest in bonds in multiple states, and therefore provide diversification. If one state's bonds are weak, other states with stronger bonds balance out the risk.
- Single-State Municipal Bond Funds: These funds invest in bonds issued in a single state. Interest on these bonds could be exempt from federal, state, and local taxes. When you buy bonds in a single state, poor economic conditions in the state affect your entire portfolio.
- Insured Municipal Bond Funds: These are a relatively low-risk investment. That's because an underwriter will pay off investors if the borrower defaults. These funds generally have lower yields than other bond funds.
- High-Yield Municipal Bond Funds: These funds invest in lower grade municipal bonds that are issued to borrowers whose credit picture appears to be improving. Buying shares in these bond funds will involve some risk, but not as much as buying shares in a high-yield corporate fund.
For More Information
The Alliance for Investor Education
You can test your knowledge about mutual funds on a Web site run by the Alliance for Investor Education. The site also features a mutual fund fee calculator and a "Guide to Understanding Mutual Funds."
URL: http://www.investoreducation.org
The Securities and Exchange Commission (SEC)
The SEC Web site offers a variety of useful information for investors. Under "Investor Education," look for online publications about mutual funds and Interactive Tools, including a Mutual Fund Cost Calculator that will help you compare the true dollar cost of mutual funds. Use the EDGAR Database (listed under "SEC Filings and Forms") to find and read a mutual fund's prospectus.
URL: http://www.sec.gov
The Investment Company Institute (ICI)
ICI is a trade organization for the mutual fund industry. The group publishes a host of information about mutual funds, including: "A Guide to Understanding Mutual Funds" and "Mutual Fund Fact Book."
URL: http://www.ici.org
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