The term bond fund refers to a portfolio of debt instruments as well as other types of indentures. Bond funds will hold debt instruments of different maturities, thereby providing investors with a steady source of income over time.
Bond funds offer individuals the ability to buy a diverse set of debt instruments, which helps to insulate the investor from interest rate fluctuations, in addition to providing a reliable source of income. As is the case with stocks, bonds vary in quality. Funds holding non-investment quality debt, such as junk bonds, will offer higher rates of return. However, the risk of default will be higher too.
The debt instruments in a bond fund are typically structured to vary in maturity. As bonds mature, the fund's management team will purchase new securities. There are a large number of specialty bond funds, including those that hold corporate, high-yield (junk bonds), government, global, international, inflation-protected, municipal, and mortgage-backed securities.
While bond funds can help insulate investors from interest rate risk, these investments cannot protect individuals from loss of principal. As interest rates decrease, the value of the bonds in a portfolio will increase, thereby providing the investor with capital appreciation. As interest rates increase, the value of the bonds in the portfolio will decrease, thereby exposing the investor to a capital loss.
Generally, bond funds are considered fairly conservative investments. Individuals choosing to hold bond funds will oftentimes have relatively low risk tolerance scores.