How To Diversify Your Portfolio With Bond Funds

Even when equities are top market performers, bonds may still have a place in your portfolio. As a complement to the more volatile nature of stock funds, fixed-income funds may have the potential to generate a steady stream of income and add stability to a portfolio.

Bond funds are professionally managed pools of individual bonds. Depending on the fund’s investment objective, its manager will buy and sell individual bonds to produce the best possible returns and generate interest income. For a retiree looking for a monthly income stream, funds tend to work better because they pay out monthly as opposed to individual bonds, which pay interest only twice per year.

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Like individual bonds, a bond fund’s value generally moves in the opposite direction of interest rates, and carries a variety of risk and reward characteristics. For example, funds that hold bonds with shorter maturities typically have lower risk profiles and lower return expectations than those with longer maturities.

Here are the most common types of bond funds:

  • Government/Treasury bond funds. These funds are made up of bonds backed by the full faith and credit of the U.S. government. They typically have lower risk levels and lower returns. Government bond fund returns may fluctuate with rising interest rates and economic conditions. Keep in mind that investments in government bond funds are not insured or guaranteed by any government agency. The funds’ performance will vary. Interest rate changes will affect bond prices, which can affect the price of the fund. When redeemed, the value of the shares may be more or less than their original cost.

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  • Tax-exempt municipal bond funds. These funds are made up of bonds issued by local municipalities, such as states, cities, and towns. The interest these bonds earn is generally exempt from federal taxes and, in some cases, state and local taxes. However, income derived from such funds may be subject to the federal alternative minimum tax. As a result, they have the potential to offer higher after-tax returns for investors in higher tax brackets. Municipal bond funds are affected by interest rate and market risk and fall somewhere in the middle of the risk/return spectrum. Keep in mind that due to the financial crisis, the risk of holding bonds from some municipalities and states has increased because of budget constraints and concerns about their ability to repay principal.

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  • Corporate bond funds. These funds are made up of bonds issued by corporations. Depending on the issuer, credit ratings can vary considerably resulting in higher levels of risk and potentially higher returns.

Whether you’re looking to reduce risk in an equity-heavy portfolio or generate a stream of income, you may want to consider diversifying your portfolio with bond funds. Keep in mind that diversification does not guarantee a profit or protect against loss. Consult a qualified financial adviser for more information on how to construct a fixed-income portfolio that suits your needs.

Doug Lockwood, CFP is a Partner at Harbor Lights Financial Group, a full service wealth-management team that has been dedicated to assisting clients in the accumulation and preservation of their wealth for over eighteen years. He was recently named one of America’s Top 100 Financial Advisors by Registered Rep Magazine (August 2010) based on assets under management.

Doug Lockwood is a registered representative with and securities offered and advisory services through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC. For more information, go to www.hlfg.com.

Mutual funds are offered with a prospectus. Investors should consider the investment objectives, risks, charges and expenses of the investment company carefully before investing. The prospectus contains this and other information about the investment company. You can obtain a prospectus from your financial representative. Read the prospectus carefully before investing.

This post originally appeared at U.S. News & World Report.

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