This answer suggested to invest in a Bond Fund and stated that it has been working well for that person. What is a bond fund? What are it's pros and cons?
As Michael Pryor answered, a bond fund is a mutual fund that invests in bonds. I'd also consider an ETF based on bonds to be a bond fund, but I'm not sure that all investors would consider these as "bond funds". Not all bond funds are the same -- just like stock funds.
You can classify bond funds based on the issuer of the bonds:
- Government bond funds (as described in the U.S.) invest primarily in bonds issued by the U.S. Federal Government. These may be tax advantaged.
- Municipal bond funds (aka "Munis") invest primarily in bonds issued by municipalities (cities, counties?). These may be tax advantaged.
- Corporate bond funds invest primarily in bonds issued by corporations. There are different "grades" of corporate bonds, based on the ratings applied to the companies by ratings agencies like Moody's or Fitch. An "AAA" fund would invest primarily in bonds issued by highly rated companies.
- High yield bond funds invest primarily in bonds issued by corporations with low ratings. (These bonds are also called "junk bonds".) These bonds typically have a higher yield (i.e. they pay a higher interest rate), but they also have a higher risk of default (i.e. the issuer goes bankrupt and doesn't pay back the principal).
- You may also find bond funds based on debt issued by foreign governments, I'm not familiar with these.
- "Blended" funds are very common -- these would invest in two or more of the categories above.
You can also classify funds based on the time to maturity:
- Short term bonds will mature in less than a year. You might also find "ultra short" or other descriptions. All else equal, shorter times to maturity mean a higher likelihood of repayment and less interest rate risk.
- Medium term bonds will mature in more time. There's a correspondingly higher risk of default and adverse affects from interest rate changes.
- Long term bonds will mature in ten or more years. These are the most exposed to interest rate fluctuations.
- Except for funds that focus on a certain maturity, most funds will spread the maturities out to spread the risk out.
In general, bond funds have lower risk and lower expected return than stock funds. Sometimes bond funds have price movements that are not tightly correlated to the price movements in the equity markets. This can make them a decent hedge against declines in your equity investments. See Michal Pryor's answer for some info on how you can get tax free treatment for your bond fund investments.
I used the term "bond fund" to mean a mutual fund which invests in bonds.
Vanguard has a list. If you live in PA, OH, MA, FL, CA, NJ, or NY there are tax free funds you can invest in on that list.
A mutual fund that purchases bonds is a bond fund. Bond funds are considered to be less risk than a traditional stock mutual fund. The cost of this less risk is that they have earned (on average) less than mutual funds investing in stocks.
Sometimes, bonds have different tax consequences than stocks.