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Bond Funds: A Staple of Investing
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At first glance bond funds might seem boring. But looks can be deceiving. Bonds come in many different flavors and target some interesting niches, such as health care, green energy, neighborhood revitalization projects, and infrastructure. More importantly, though, they can be an essential ingredient in building a diversified portfolio as they often move in the opposite direction of stocks.
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At their most basic, bonds are loans. When you buy a bond, you become a lender to an institution. Your loan lasts a certain period of time—until the date when the bond reaches maturity—and you get a certain dividend payment each month as interest on the loan. That interest is generally higher than money-market funds or Guaranteed Investment Contracts (GICs).
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There are two basic types of bonds: government bonds and corporate bonds. Typically, bonds funds are safer than stock funds, but that doesn't mean they are risk-free. Bonds, for instance, can lose part of their value when interest rates rise, since everyone can invest elsewhere at a higher interest rate. There's also the risk that whoever sold the bond might default, or not be able to make payments (this is known as credit risk).
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Funds that buy bonds backed by the US government are typically safe, since they are backed by the full faith and credit of the US government. Funds that invest in municipal bonds, from state and city governments, are also pretty safe. The interest you earn from municipal-bond funds is usually free from federal taxes, and sometimes state taxes.
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Corporate bond funds, which buy bonds issued by companies, earn more interest than government bond funds, but are riskier. Companies can go bankrupt, after all, and might not be able to pay off their debts. The riskiest US bond funds invest in bonds put out by companies with questionable credit. These funds, called high-yield bond funds, or junk-bond funds, typically pay out the most interest.
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When shopping for bond funds for your portfolio, always look at the fund's expenses because bonds typically gain less than stocks over time and, as a result, their costs can become a heavier burden.
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