Municipal Bond Funds

Municipal bonds (munis) are issued by state and local governments and agencies to fund projects and pay bills. They are generally exempt from federal taxes. You can buy a municipal bond fund for just one state, and these are also exempt from state taxes if you live in that state. Munis should not be a part of tax-deferred retirement accounts like 401(k)s because you don't pay current taxes on the earnings in the account. Whether they should be part of your non–tax-deferred portfolio depends on your federal income tax bracket (the higher it is, the more favorable munis are).

There are risks associated with bond mutual funds that may include interest rate risk, credit rating risk, and default risk. For a more detailed explanation of risks associated with a particular fund, consult your financial professional.

Muni funds come in three maturity lengths: short, intermediate, and long; they also come in three qualities: high, medium, and junk or high yield.

Government Bond Funds

Government bonds are issued by the Treasury and by government agencies such as GNMA (Government National Mortgage Association) and FNMA (Federal National Mortgage Association). Those issued by the Treasury are called, logically enough, "Treasuries." Those issued by federal agencies are called "agency bonds" or "mortgage-backed bonds." That does not mean you can't lose money on them, however. Interest rate swings can dramatically alter the value of these bonds.

Government bond funds, especially Treasuries, are designed to form the bedrock of an investor's bond portfolio. They come in only one quality: high, because the risk of default is considered to be highly unlikely; they also come in three maturity lengths: short, intermediate, and long.

Corporate Bond Funds

Corporate bonds are issued by companies as a way of making capital investments and paying their bills.

They are generally only as secure as the company issuing them. Bonds issued by blue-chip companies generally get the highest ratings. Because they are regarded as very stable, they also pay the lowest percentage interest of any corporate bond. A company can also have bonds of different quality, depending on whether or not the debt is secured by an asset (in the same way that your mortgage debt is secured by a house) or where it stands in order of payment priority. The higher it stands, the better the rating.

Corporate bond funds come in three qualities: high, or investment grade; medium; and junk or high yield. They also come in three maturities: short-term, immediate-term, and long-term.

Global Bond Funds

Global, or foreign, or world bond funds, are composed of debt securities from foreign governments or corporations. Some funds include U.S. bonds. Foreign bonds are much harder to rate than U.S. bonds. Because foreign bonds are held in the currency of the country where they are issued, they rise and fall not only on the fortunes of the issuing organization, but also with the exchange rate.