Government Bond and Money Market Funds

A government bond fund is a bond mutual fund that invests in debt instruments issued by the U.S. government and its agencies. The broad category of government securities includes U.S. Treasury securities (e.g., T-bills, T-bonds). It also may include mortgage-backed securities issued by government agencies such as the Government National Mortgage Association (GNMA).

Government bond funds are considered the least risky of bond funds because the U.S. government guarantees payment of interest and principal on the underlying securities.

The relatively low-risk nature of government bond funds makes them appropriate for highly conservative investors who seek current income. However, because of the expected overall lower returns associated with government bond funds, they may have less value for aggressive investors. A government securities money market fund can be used in much the same way as any other money market mutual fund.

Lower default risk relative to other bond funds

The U.S. government is considered one of the more creditworthy entities in the world; this creditworthiness also applies to its securities-issuing agencies. In fact, the U.S. government has never once defaulted on or called (i.e., redeemed prior to maturity) one of its debt instruments. Accordingly, a fund that specializes in U.S. Treasuries exposes investors to a lower degree of default risk. And in the case of a money market fund, the securities it holds mature quickly, so default risk is even lower than that of government bond funds, which invest in longer-term securities.

Current income with some tax advantage

Like all bond funds, government bond funds seek to provide shareholders with a steady stream of current income from fund dividends. These funds would be suitable for retirees and other investors who require a low-risk supplementary income source to help meet expenses. Even if you don't plan to spend the income, you can reinvest the dividends in more shares of the fund, or in some other investment. That income also can help balance volatility from other investments in a portfolio.

Moreover, government bond interest (and, by extension, government bond fund dividends) is tax exempt at the state and local (but not federal) levels.

Relative liquidity

As with any money market mutual fund, a government securities money market fund typically provides relative stability compared to other debt instruments, and generally can be converted to cash easily.

Relatively low returns

Because the risk posed by such funds is relatively low, returns will usually be correspondingly low. As a result, such funds might not be appropriate as the sole investment choice for money designed specifically for a long-term goal, though they might be appropriate as part of an overall portfolio.

Interest rate risk

Most bond investments face interest rate risk. A bond's value fluctuates as current market interest rates change; as a result, the value of a government bond fund will fluctuate as well. (However, as noted above, government securities money market funds try to preserve a $1 per-share value.) That means when interest rates rise, the value of a bond fund can drop; conversely, when interest rates fall, bond prices rise.

Inflation risk

Inflation risk refers to the possibility that the return on your investment won't keep pace with increasing prices. As prices rise, the buying power of a dollar falls, reducing your ability to purchase goods and services. As with any bond fund, that drop in buying power affects the value of a government bond fund's interest payments.

However, unlike with individual bonds, a government bond fund's manager may be able to adjust the fund's duration to try to cushion the impact of inflation on the fund's returns--for example, by purchasing longer-term bonds that pay higher interest rates--if the fund's charter allows such changes. Also, a government bond fund that invests in Treasury Inflation-Protected Securities (TIPS) is designed specifically to address the challenge of inflation. The securities held by a TIPS fund adjust the principal and interest paid every six months to reflect changes in the Consumer Price Index. A TIPS fund generally invests in a variety of maturities, and pays out not only the interest but any annual inflation adjustments to the bonds it holds. Like other government bond fund dividends, those payments are tax-exempt at the state and local levels. However, if inflation is lower over time than expected, a TIPS fund could have lower returns than an ordinary government bond fund.

Because short-term securities offer a relatively low fixed rate of income, money market funds are particularly susceptible to inflation risk. If the return on your shares is lower than the inflation rate, your investment dollars may not keep pace with rising costs and your income may lose purchasing power.