What's the Best Way to Buy Bonds?

Investors can buy individual bonds and hold them to maturity to avoid losing principal along the way.

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Investors who have become accustomed to a steady decline in interest rates over recent years may not want to get too comfortable. After bottoming near 2 percent late last year, the yield of the 10-year treasury bond made its way up to 3.6 percent as of Wednesday. When rates rise, the price of existing bonds fall, which can mean losses for some types of bond funds. Do-it-yourself investors, take note: You can protect your portfolio from rising interest rates by investing in individual bonds. But this method may not be feasible for all investors because it can be costly and time-consuming.

If you hold individual bonds to maturity, you'll get all of the interest payments along the way with a full return of your principal payment. The price of individual issues will fluctuate, but you'll get your money back, including interest, when they mature. Bond fund investors, on the other hand, could see losses in the near future if rates continue to rise because managers are actively buying and selling bonds. "If they do that well, they can add value for you," says Richard Barrington, a personal finance expert with Moneyrates.com. "If they do that less successfully, then there's no guarantee you're going to realize the yield that you think you're getting when you get into [the fund]."

[See 5 Things Investors Should Know About Mutual Funds.]

Experts say buying individual bonds may only be appropriate for investors who have between $100,000 and $200,000 or more to create a diversified fixed-income portfolio. With bond mutual funds, on the other hand, you leave the security selection to the experts, who invest in a basket of diversified securities. Many bond funds have much lower minimum investments of, say, $5,000 or $10,000.

[See How to Navigate the Bond Market in 2011.]

Because buying individual bonds can be tricky, investors must do their homework. Researching corporate bonds, for example, is similar to analyzing individual stocks, says Barrington. When you invest in a single company's bonds, you're essentially taking on the risk of that company. Marilyn Cohen, author of the upcoming book Surviving the Bond Bear Market, suggests investors use sites like Investinginbonds.com to learn how to invest in individual bonds, as well as find the prices and yields for various sectors of the bond market.

Some types of bonds require less research than others. For example, treasury securities, which are backed by the full faith and credit of the U.S. government and pose virtually no credit risk, can simply be purchased through Treasury Direct.

A relatively new way to invest in corporate bonds is through Guggenheim BulletShares Corporate exchange-traded funds. These seven funds hold bonds with maturity dates of 2011 through 2017. (To clarify, the bonds for Claymore BulletShares Corporate Bond 2011 all expire in 2011.) With these ETFs, investors can purchase a diversified mix of bonds with similar maturity dates instead of selecting individual bonds. Guggenheim also recently introduced four high-yield ETFs.

[See 3 Income Strategies for Retirees.]

With interest rates still near historic lows, Barrington says he would consider alternatives to bonds. Right now, some investors may be better off stashing their savings in money market accounts because their yields aren't much lower than some short-term bond funds. And unlike bond funds, many money market accounts don't charge annual fees. "[Fees are] especially important in a low-yield environment because there is just not much return to be giving up in this environment," he says. Interested investors can uses sites like MoneyRates.com or Bankrate.com to research money market and certificate of deposit accounts. Barrington suggests parking your money in a money market account until rates have risen somewhat, then investing in individual bonds or bond funds.

Twitter: @benbaden