Government bond fundsHow they're valued: Government bond funds are mutual funds that invest in debt securities the U.S. government and its agencies issue. The funds invest in debt instruments such as T-bills, T-notes, T-bonds and mortgage-backed securities issued by government-sponsored enterprises such as Fannie Mae and Freddie Mac.
Risks: Funds that invest in government debt instruments are considered to be among the safest investments because the securities are backed by the faith and credit of the U.S. government. However, like other mutual funds, the fund itself is not government-backed and is subject to risks -- namely interest rate fluctuations and inflation. If interest rates rise, bond prices decline, and if interest rates decline, bond prices rise. Interest-rate risk is greater for long-term bonds. Further, if the inflation rate rises, purchasing power can be diminished.
Liquidity: Bond fund shares are highly liquid, but their values fluctuate depending on the interest-rate environment (see risks, above).
Pros and cons: Government bond funds are considered low-risk investments that can provide diversification to investment portfolios heavily weighted with stocks. They tend to pay higher dividends than money market and savings accounts and typically pay out dividends more frequently than individual bonds, sometimes monthly. Moreover, certain government bond funds are exempt from state and local taxes.
Where to find them: Shares held in bond funds can be bought and sold through your mutual fund company or brokerage firm.
Caveats:They may seem like funds that should provide very smooth returns, but in fact government bond funds can be quite volatile. For example, long government funds shot up 27.67 percent in 2008, according to Morningstar. But during the first five months of 2009, they were down nearly 15 percent. What's up? "There's no single pat answer for this, but it's probably a combination of Treasury yields having fallen so low that fears of a 'bubble' in Treasury prices clearly began making the rounds, and there was likely selling on the basis of that alone," says Eric Jacobson of Morningstar. "More broadly, there's a lot of hand wringing about what all of the current government spending is doing to the budget deficit and overall indebtedness of the country."
Over one year through May 31, long government funds show a 7.69 percent gain. Meanwhile, intermediate and short-term government bond funds over the same time frame are up 5.44 percent and 4.89 percent, respectively.
Words of caution: "If you're looking at government bond funds, make sure you understand what you're looking at because there are all different types. If you buy a Treasury fund, buy a really cheap one (with a low expense ratio) because there's not a whole lot a manager can do to add value there. If it's a mortgage fund, you really want to take a careful look and make sure you understand what the investment strategy is and that the managers seem to know what they're doing. Government mortgage funds are safe from a credit perspective because now essentially Ginnie Mae, Fannie Mae and Freddie Mac are all backstopped by the government. When you're buying a mortgage fund that's being labeled a safe Ginny Mae government fund, there's potentially more volatility risk in there than you might expect. So just make sure that you know what you're buying."-- Eric Jacobson, fixed-income investment specialist, Morningstar, Chicago.