In the wake of the recent volatility in the stock markets around the world, many investors have asked me – is it time to turn to bonds? My first response is that all investors should have some fixed income in their portfolios. Beyond that – the total investment, exact allocation, and maturity – depends on your individual circumstances. And to determine the answers to those questions requires a brief explanation of the industry and the available instruments.

To begin with, let’s define bonds. They are essentially loans that are securitized. State and Federal governments, their agencies, and corporations are the borrowers, which need funds for projects such as roads and/or ongoing operations. And the folks who buy bonds are the lenders; you are putting up your cash so the borrowers can complete their projects. In return, the borrowers promise to pay back the principal – the original loan – as well as some interest, or coupon, which is paid on a regular basis. Because they promise to pay back your original investment, bonds are typically deemed more conservative than purchasing equities (although there are bond categories – such as junk – that defy this characterization).

In addition to being perceived as steadier, stable investments, investors have two primary reasons for buying bonds:

1. As stated earlier, bonds create regular income streams, which increase in importance as you near retirement.

2. Since the bond market almost always behaves differently than the stock market, bonds can add important diversification to your portfolio, reducing its overall risk, but…

There are some risks to investing in bonds

All investments carry risks, and bonds are no exceptions – they just include a few risks that are unique to fixed-income investing.

Credit risk is the risk that the bond issuers default, or fail to pay the debt that they owe on the bonds they have issued.

Prepayment risk is the risk that the issuers of the bonds will prepay them during times of declining interest rates. For the issuers, that’s good news, as they can issue new bonds that won’t cost them as much, but for the bond holders, they will have to reinvest their proceeds at lower rates, decreasing their income.

Interest rate risk is the risk that the market value of the bonds owned by a fund will fluctuate as interest rates rise and fall. Bond prices move opposite to interest rates; when rates rise, prices decline, and vice versa. And the longer you hold a bond, the higher this risk is.

A bond or bond fund – Which is best?

The complexities of pricing and buying individual bonds, as well as the hefty cash outlay, often keep investors from participating in the bond markets. To encourage bond investing, the investment world created bond funds, which are professionally managed mutual funds that invest in bonds or other debt securities.

With bond funds, you will receive monthly dividends that are composed of the regular interest payments on the underlying securities as well as any capital appreciation in the prices of the portfolio's bonds.

Those dividends are another reason investors like bond funds, since they are generally paid out more frequently than with individual bonds. And like individual bonds, bond funds can add diversification to a portfolio heavily weighted in stocks, are more liquid than individual bonds, and give investors the benefit of professional management.

The disadvantages are similar to all mutual funds, including the sometimes-high fees and expenses that can significantly reduce your returns. Additionally, the constant trading in a fund will also continuously alter the risk-return profile of the fund, increasing it or decreasing it over time, whereas the risk level in holding an actual bond actually decreases the longer the holding period.

As well, investors can precisely ladder a portfolio of individual bonds to mature exactly when you want them to, which is almost impossible with bond funds.

Nevertheless, bond funds offer many investors who don’t have the wherewithal or time to invest in individual bonds a nice option to participate in the fixed-income markets.

Bond funds come in many flavors

Bond funds – like other types of mutual funds – also have a net asset value (NAV). NAV is equal to the dollar value of one share in the fund, or the price to buy or sell a share in the fund.

Most bond funds are composed of bonds of a specific type, maturity, and risk profile.

U.S. Bond Funds invest in debt securities issued by the U.S. government (Treasury bills, notes, and bonds) and its agencies (mortgage-backed securities issued by agencies such as Fannie Mae). Because the underlying securities are backed by the full faith and credit of the U.S. government, these funds are deemed to be the safest of the bond funds. Some of these funds are exempt from state and local (but not federal) taxes. The biggest risks involved in investing in these funds are related to fluctuating interest rates and inflation.

Municipal Bond Funds invest in debt securities issued by state and local governments that need funds to finance public projects, such as infrastructure and schools. Many of these bond funds are exempt from federal taxes and, sometimes, from state taxes, too.

Generally, munis are considered safe, as they are backed by their governments, but because some municipalities have gone bankrupt, these funds do carry more risk than U.S. government bond funds.

Corporate Bond Funds invest in bonds issued by corporations. They do not come with government guarantees, so the risk of default is a possibility. To reward investors for this risk, the income paid out by these funds is usually much higher than muni or U.S. government bond funds. These bonds are rated by the primary bond rating agencies, with the investment-grade rating bestowed on the most creditworthy of companies. Junk or high-yield bonds are generally rated lower, but offer potentially higher returns. Usually, the lower the rating, the higher the return, and the greater the risk of default.

Mortgage-Backed Bond Funds invest in bonds that are backed by pools of mortgages, which can be offered by the U.S. government, banks, or other financial institutions. They generally offer higher rates of returns than government, agency, or muni bond funds, but are also subject to prepayment risk during declining-rate environments, and default risks in times of economic distress (such as we have been seeing lately).

Broad market bond funds consist of some of each: U.S. government and agencies, municipals, mortgage-backed, and corporate bonds.

Additionally, there are other bond funds that include zero-coupon funds, international funds, and convertible securities.

Bonds often are categorized by maturity date, as follows:

Short-term Bond Funds include bills, CDs, and commercial paper, which generally are about two years from maturity.

Intermediate-term Bond Funds include notes that are between two years and ten years from maturity.

Long-term Bond Funds consist of holdings that have more than ten years remaining until they mature.

Generally, the longer the duration of the investments in a bond fund, the higher the potential returns but the greater sensitivity to change in interest rates. If you are looking for less volatility, you may want to invest in shorter-term funds.

Some additional considerations

Do you want a taxable or tax-advantaged bond fund? Tax-advantaged are generally more suited to non-retirement accounts and for higher-income investors.

How much of your portfolio should you allocate to bond funds? This will depend on your personal circumstances, including the length of time before your retirement and how quickly you will need to tap your retirement funds. A general rule of thumb is that the closer you are to those golden years, the more conservative your investments should become.

There are a variety of search engines on Internet sites that will help you identify the best bond funds for you. I particularly like Morningstar’s free Fund Selector (http://www.morningstar.com/cover/funds.aspx), but you can also just Google ‘bond fund screeners’ and find a variety to choose from.

Parameters I like to use include: taxable or non-taxable, minimum purchase requirements, expense ratios, Morningstar’s Star rating, five- and 10-year annualized returns, style (which includes credit quality and duration of holdings), and volatility of returns.

Bond funds can be a great addition to your portfolio, adding needed diversification and income. But remember that your personal circumstances should dictate the composition of your portfolio, and I never encourage investors to put all of their eggs in one basket – be it stocks or bonds – no matter how the markets or economy are faring. A wide array of assets scattered among different classes will provide a safety net as well as an opportunity to benefit handsomely when one of those classes is on the upswing.

Originally published on January 29, 2008 in Financially Fit.