Investors who seek current income from their holdings will often find what they are looking for with mutual funds that invest in bonds. There are thousands of bond funds currently available that invest in all types of fixed-income instruments with varying degrees of risk, volatility and rate of return. Understanding how these instruments work can help you to determine whether and how they can best fit into your portfolio.

Bonds are debt instruments by nature. Investors who purchase bonds become creditors of the issuer, who is required to pay back the investor’s principal plus a stated amount of interest according to a preset schedule. When the repayment schedule is complete, the bond matures and the principal is returned to the investor. If the issuer becomes unable to do this, then it has defaulted on the bond issue.

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There are three main types of bonds:

• Government – Backed either directly or indirectly by the U.S. Treasury. Includes T Bills, Notes and Bonds as well as TIPS and Savings Bonds. Also includes agency securities such as Fannie Mae and Sallie Mae. Treasury securities are considered to be safest securities on earth.

• Municipal – Issued by cities or other municipalities. There are two types of municipal bonds. General Obligation bonds are backed by the taxing authority and financial strength of the issuing municipality and revenue bonds are backed by the income that will be generated from whatever project, such as a sports facility or toll road that the project that the bonds are being issued to pay for will generate in the future. Municipal bonds are second only to Treasury securities in terms of safety of principal. The interest from municipal securities is usually tax-free at the federal and state level and often at the local level as well for investors who live in the jurisdiction of the issuer, and they are typically most appropriate for investors in the highest tax brackets.

• Corporate – Because these bonds are only backed by the financial strength of the issuing corporation, they are considered the riskiest type of bond and therefore pay the highest rates of interest. Corporate bonds that are rated BBB or below are considered “junk” bonds, and issues in this category often pay considerably more than other types of bonds-and carry a proportionately higher risk of default.

Bonds can be purchased and structured to accomplish many different objectives. Junk bonds can be used to generate higher yields, while municipal offerings can produce tax-free income. Treasuries will guarantee your principal and provide state-tax exempt interest. Bonds can also generate capital gains if they are purchased in the secondary market during periods of high interest rates because there is always an inverse relationship between bond prices and yields.

Therefore, when a bond is purchased when rates are high, it will be worth more if rates decline and can often times be sold at a premium.

There are bond funds that invest in every type of bond in existence (except for savings bonds, which are not publicly traded). Some funds focus exclusively on one type of bond, such as the municipal issues from a specific state (Eaton Vance Funds offers a fund of this type for virtually every state in the union). A general list of the types of bond funds available includes:

• Government Securities Funds – These funds stick with issues that come from the U.S. Treasury. They may include agency securities such as Freddie Mac, or they may invest only in truly guaranteed offerings such as T Bonds. The American Century Government Bond Fund (CPTNX) is one such example that focuses on government issues with intermediate maturities.

• High-Yield Funds – These funds invest in junk bonds and other more aggressive income-producing instruments such as convertible securities and junk bonds. They are designed for investors who are willing to endure greater risk and volatility in return for higher income. One example is the T. Rowe Price High Yield Fund (PRHYX).

• Bond Index Funds – These funds purchase all of the securities that are held inside a given bond benchmark index. The F Fund in the Thrift Savings Plan for government employees mirrors the Barclay’s Capital Aggregate Bond Index, which holds treasury, corporate and foreign bonds.

• Municipal Bond Funds – These funds purchase securities that are issued by municipalities either in a given jurisdiction or around the country. Eaton Vance offers a wide range of municipal funds, including their National Municipal Income Fund and state-specific funds such as the Missouri, Maryland and Georgia Municipal Income Funds (ETMOX), (ETDYX) and (ETGAX).

• Corporate Bond Funds – These funds purchase investment-grade bonds from major corporations in order to generate stable income. One example is the Fidelity Corporate Bond Fund (FCBFX).

• Global Bond Funds – These funds purchase bonds from issuers around the world as a means of diversifying income and reducing political risk. An example of this is the Kemper Global Income Fund (KGIAX).

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Bond funds offer the same set of advantages as other types of mutual funds, such as diversification, professional management and, perhaps most importantly in this case, liquidity. One chief drawback that comes with owning individual bonds is that the investor may have difficulty redeeming them before they mature.

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If they can sell them in the secondary market, then they will often have to part with them at a substantial discount for which they will take a loss. But this is not the case with bond funds, which allow investors to buy and sell shares at any time regardless of the lengths or dates of the maturities held inside the fund.

Bond funds also blunt the risk of default by a given issuer because the income generated from all of the other fund holdings can offset the loss from the insolvent entity. Municipal income seekers can also save themselves time and effort by investing in municipal funds that purchase bonds solely in their jurisdiction. Tax reporting for bond fund holders is also usually simpler than for those holding individual issues because the fund will usually break down all forms of interest paid according to its tax category, such as taxable, tax-free at one or more levels and any capital gains or losses. They also usually include any amounts of OID (Original Issue Discount) and foreign tax paid.

There are several ways to rank bond funds, such as by yield, AUM and management tenure. TheStreet.com has created a list of what it considers to be the 20 best bond funds according to its ranking methodology:

Bond funds provide investors who seek income with reduced risk of default through diversification and professional management as well as liquidity. There are many different types of funds in this category that are categorized by the level of risk, taxability of interest and types of issuers that they purchase. For more information on bond mutual funds and how they can benefit you, consult your stockbroker or financial advisor.