These days I get that question a lot – what is the best bond fund for 2010? After the stock market volatility of 2008-09 people have realized that a portfolio needs to comprise of stocks and bonds. In this article, we will discuss how bonds work and how to go about picking the best bond fund.

What are bonds? They are a form of loan, made to a company. The owners of the loan are called bondholders. Each bond is issued with a fixed face value, has a coupon rate associated with it and a date of maturity.

The amount an investor pays to buy the bond is called the face value. This payment entitles the bondholder to receive interest payments at fixed intervals (usually every six months). On the date of maturity (which is known in advance), the principal (or the initial payment made) is paid back completely.

Bonds have been an ideal choice for investors looking to get a higher return than they would get from CDs, US treasuries etc. Investing in individual bonds is a little more involved and requires experience and knowledge.

This is where bond funds are a great option. They are professionally managed funds that yield dividends and are usually low-cost funds. We have a couple of options that need further discussion.

There are high-yield funds that invest in high-risk bonds. They pay higher dividends because of the higher risks involved but the bond in this fund are usually junk. So, this might not be the best choice.

Next, we have long-term funds that pay above-average dividends. These bonds are exposed to higher interest rate risk so we might not want to consider these. We also have foreign funds. But these are exposed to foreign exchange risk or currency fluctuations. These are a little risky for our liking.

We also have lower dividend paying funds like government funds. These funds invest in U.S. Treasury bonds, which are safe as it gets. Although they are safe, their dividends are pretty low and they aren’t an ideal investment for us.

So, what would the best bond funds look like? They will have higher-quality bonds which mature in the medium-term. They don’t have to be the best quality because the dividends would be too low for our liking. There are bond funds which are offered by mutual funds companies. They have yields above 6% but they can be expensive to own.

We like no-load, medium term bond index funds. They are cheap and their annual expenses are low.