3. Take a close look at the bond fund prospectus that a broker or the fund firm must provide. Not all bonds in a government bond fund are government bonds, for instance. Also, pay attention to fees. Individual bonds also have prospectuses, which derive information from a bond's indenture, a legal document that defines the agreement between bond buyer and bond seller. If opting for individual bonds, make sure your broker is experienced in fixed income, not just stocks. Check broker credentials and disciplinary history using FINRA BrokerCheck.
4. Ask your broker when, and at what price, the bond last traded. This will give you insight into the bond's liquidity (an illiquid bond may not have traded in days or even weeks) and competitiveness of the pricing offered by the firm, FINRA advises.
5. Understand all costs associated with buying and selling a bond. Ask upfront how your brokerage firm and broker are being compensated for the transaction, including commissions, mark-ups, or mark-downs.
6. Consider reinvesting coupons, or interest payments, right away in order to compound your returns. But plan ahead. It's a good idea to set up a "coupon account" at the outset if this is your intention. Bond funds automatically reinvest coupons.
[See 10 Great Dividend Stocks for 2012.]
Each year, fund tracker Morningstar compiles a roster of top bond fund managers. Reading some of the criteria behind the picks can help investors determine if those traits fit their own fixed-income investing philosophy. For example, the most successful managers seem to manage just the right mix of sticking to a disciplined approach but with just enough "risk taking" sprinkled in to make the fund do some heavy lifting. Manager resumes may go a long way toward raising your comfort level and helping determine if the costs and benefits of fund ownership are justified.
Last year was a true test of bond-fund manager mettle. Most pegged the treasury rally as finished a year earlier, only to watch the market soar again in 2011. Those managers who set themselves apart still managed some government bond exposure; their expertise, bucking conventional wisdom, paid off.
"Even among those active managers who were more sanguine about the Treasury market environment, few, if any, even maintained a fully neutral allocation to the sector, which comprised more than 34% of the Barclays Capital U.S. Aggregate Bond Index at the end of November," notes Eric Jacobson, Morningstar's director of fixed-income research.
As with any investing, homework should come first. Among select resources:
• The government's TreasuryDirect provides educational information, as well as the opportunity to buy Treasuries online and over the phone.
• The Investment Company Institute tracks bond fund inflows and outflows. The association also offers literature on bond mutual fund risks. Securities Industry and Financial Markets Association, or SIFMA, offers an Investing in Bonds education page.
See U.S. News's top-ranked taxable bond funds and municipal bond funds.
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