5 Things You Need to Know About Bonds

You can lose money in bonds.

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Investors continued to pour money into bond funds last year, even though bond prices fell in November and December. In 2010, investors added $234.8 billion to taxable bond funds and yanked $28.8 billion out of stock funds, according to the most recent net new cash flow data from the Investment Company Institute, which tracks mutual fund flows. If you're thinking about jumping on the bond bandwagon, here are some things you need to know before you buy:

You can lose money in bonds. When interest rates go up, the value of existing bonds goes down. The longer the maturity or duration of the bond, the more the value will drop as interest rates rise because investors are stuck with the bond's interest rate for longer. That's why we recommend sticking to bonds with maturities of five years or less. (For more tips, see my previous post where I warned about a bond bubble.) The value of the bonds will decline if rates go up, and you can lose money in bonds if you're required to sell the bond prior to maturity.

Bond funds are better than buying individual bonds. I'm a big proponent of bond funds because not all individual bonds behave the same way. Some bonds are riskier than others depending on what's going on in the markets and the economy. For example, there has been a lot of talk lately about whether municipalities will be able to repay their bonds. The good news is, smart bond fund managers will likely avoid the bad places to invest. Managers don't just specialize in picking the right bonds, they also know how to stay away from the bad ones.

[See Why You Should Still Buy Bonds.]

Another reason to buy a bond fund rather than a few individual bonds is most people don't know when to sell a bond. When a bond goes up in price, it may or may not be a good time to sell. Professional fund managers are better at evaluating when to sell and buy a security than individual investors.

In addition, with a bond fund your money is spread amongst a large, diverse group of bonds. If one of the issuers should happen to default, it won't have as dramatic negative effects on your total investments than if you had the concentrated risk in one particular bond.

Different types of bonds go in and out of favor. Not all bonds are safe. Just like certain sectors of the stock market, different types of bonds have cycles, too. Treasury bonds, which are backed by the U.S. government, are typically safer bond bets, although they're sensitive to interest rate changes. High-yield bonds and emerging markets bonds can sometimes offer fat yields for stretches of time because they carry more risk. Before you buy a bond fund, check to see what types of bonds it holds. Make sure the bond fund fits your tolerance for risk.

[See Understanding Basic Bond Investing: It's All About Balance.]

Buying a bond costs more for individual investors. When you buy a bond, you're playing on a field with professionals and competing against them. It's sort of like me trying to score a touchdown against the best defensive lineup in the NFL. Fund managers buy millions of dollars worth of bonds at a time, so their costs are substantially less per transaction than an individual purchasing one. Individual investors should stick with bond funds to keep those transaction costs low.

Inflation will eat away your investment returns. Given that interest rates have been low for so long, there's not much room to stay ahead of inflation. The yield on the 10-year Treasury note is around 3.6 percent, while the consumer price index, a measure of inflation, rose 1.5 percent year-over-year in December. Every year, inflation reduces your investment returns. That means you'll have less purchasing power over time. If you want to maintain the same lifestyle throughout your retirement years, you're going to need more spending money every year because of inflation. That's why it's important to establish your retirement plan early, and mix growth investments such as stocks with more stable fixed-income investments.

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Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast-to-coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC-registered investment adviser, which provides mutual fund and asset allocation recommendations, and research to stores in The Mutual Fund Store system.