There are four types of bond funds: Mutual funds, closed-end funds, unit investment trusts (UITs) and exchange traded funds (ETFs). While there are important distinctions between them, each type of fund allows an investor to instantly diversify risk among a pool of bonds at a low minimum investment. For those without a lot of money to invest, or who are investing through an employer-sponsored retirement plan, such as a 401(k) or 403(b) where mutual funds are the primary investment option, bond funds may represent the only realistic option to add this important asset class to your portfolio.
Before you invest in a bond fund, it is important that you understand the different fund types and how bond funds differ from individual bonds. For instance, one common misconception about bond mutual funds is that there is no risk to principal. This is not the case: Your initial and subsequent investments will fluctuateand indeed may declinejust as they do if invested in a stock mutual fund.