What are bond funds?

Bond funds, sometimes called debt funds, can give many investors a source of income for their portfolio. They also may have less risk than many stock funds, but bond funds can still lose value. That makes them a popular choice for conservative investors, for people who want potential for income and for anyone looking to add diversification to a portfolio.

If you are planning for the future, understanding bond funds can help you think about how income and risk may fit your goals. Consider connecting with your State Farm agent to help you review what makes sense for your situation.

Quick answers about bond funds

Here are quick answers to common questions about bond funds.

What is a bond fund?

A bond fund is an investment that holds bonds, which can be available as a mutual fund or an exchange-traded fund (ETF). This can include municipal bonds, government bonds, corporate bonds and convertible bonds. Some bond funds may also invest in mortgage-backed securities.

Some bond funds are managed to pay a higher income. Others are managed to help reduce price volatility or focus on capital preservation. Still others are managed to seek the best mix of income and price changes. This is often called total return.

If you want a regular income check, you may focus on the fund’s yield (income relative to its price). If you want diversification, you may focus more on the idea of total return.

Investors who want more income than a money market fund or a bank account may consider bond funds. Bond funds can fluctuate with interest rates and may lose value, but they have potential to be a less volatile part of a diversified portfolio than many stocks.

How bond funds make money

Bond funds can affect your return in two main ways:

1. Income from interest payments

• Bonds pay interest, and bond funds may share income with investors.
• Yield is one way people describe this income.

2. Changes in bond prices

• Even though many bonds pay relatively predictable interest, bond fund values can move when interest rates and credit conditions change.
• Yield and total return are connected, but they are not the same. Yield is mostly about income, while total return includes income plus price changes.

Types of bond funds

Some specific types of bond funds include:

• Investment-grade bond funds
  • The bonds in this type of fund are typically seen as having a lower risk of default and often have higher ratings from major credit agencies.
  • They can include bonds issued by the U.S. Treasury, other government agencies and some corporations.
  • Many mortgage-backed securities in the fund may also be rated investment-grade.
• High-yield bond funds
  • These funds are sometimes called “junk bond funds.”
  • They typically contain corporate bonds rated below investment-grade and are generally riskier.
  • High-yield bonds typically pay higher interest rates, which can lead to higher income and total returns, but with more credit risk.
• Municipal bond funds
  • These hold bonds issued by cities, states and other municipalities.
  • Municipal bonds often have a lower yield than taxable bonds with similar credit quality.
  • Some investors like them because the interest may be free from federal income taxes, depending on your situation.
• International and global bond funds
  • These bond funds include bonds from non-domestic governments and companies.
  • They can add diversification, but they may include added risks and rules tied to other countries.
  • International bond funds can also be more sensitive to global events.
• Multisector bond funds
  • These funds invest across a range of taxable bonds.
  • A multisector fund may hold high-yield bonds, treasury bonds, corporate bonds and foreign bonds.
  • The mix can vary by maturity, issuer, credit quality and average duration.
  • This can give investors more ways to seek income across different bond types.

Bond funds vs money market funds and CDs

Bond funds are not the same as cash-like options.

• Money market funds and CDs may feel more stable
• Bond funds may offer more income potential
• Bond funds can still fluctuate in price due to interest rate and credit risks

Bond funds vs bond ETFs

Bond funds are often mutual funds. Some bond funds may also be available as ETFs.

• ETFs usually trade during the day like stocks
• Open-end mutual funds typically set a price at the end of the trading day
• Either way, you still want to check what bonds the fund actually holds

When to seek guidance

Bond funds are investments, not insurance. But your financial plan may include both investing and insurance. If you are unsure how bond funds fit your goals, time horizon and risk level, consider talking with a State Farm agent to help review your overall financial picture and protection needs.

Frequently asked questions

1. Q: What are bond funds used for?
   A: Many people use bond funds for income and diversification, especially if they want less volatility than many stock funds.
   
2. Q: What is the difference between yield and total return?
   A: Yield focuses mainly on income. Total return typically includes income and any change in the value of the bonds inside the fund.
3. Q: Do municipal bond funds have tax advantages?
   A: Municipal bond interest may be tax-free at the federal level for some investors. Your exact tax result depends on your situation.
4. Q: Can bond funds lose money?
   A: Yes. Bond funds can drop in value when interest rates or credit conditions change, even if the underlying bonds pay fixed interest.
5. Q: Are bond funds safer than stocks?
   A: It depends. Bond funds can have less risk than many stock funds, but they are not risk-free. They can still fluctuate with interest rates and credit conditions.
6. Q: Do bond funds guarantee income or principal?
   A: Bond funds do not usually guarantee a set return. Even though bonds may pay interest, the value of bond funds can change. If interest rates change or some bonds in the fund face credit problems, the fund’s price may fluctuate. Your results can depend on the fund’s bond types, risk level and market conditions.