What are bonds?

Bonds are issued by the goverment or corporations. When you buy a bond, you agree to lend a certain amount of money to the issuer for a certain period of time, and at a pre-determined interest rate. At the end of the period, you will get the original amount of money back. Interest will be paid to you regularly until the period ends.

Bonds are issued by the U.S. Treasury, U.S. government agencies, corporations, and state or local governments. They can be short-term (less than 5 years), intermediate-term (5-10 years), or long-term (more than 10 years).

US Treasury bonds have the lowest-risk, or highest credit. Therefore it has relatively low interest rate. Corporate high-yield bonds (also called junk bonds) have the highest risk, or lowest credit. Municipal bonds, issued by state or local government, usually pay low interest rates, because they are exempt from federal (and sometimes state) taxes.

Investing in bonds has two benefits: regular income (bonds generally pay higher interest than bank CDs), and diversification (bonds are less volatile than stocks). It's especially good for people who are or close to be retired.

The value of bonds generally falls when interest rates rise, and rises when interest rates fall. The worst thing that can happen to a bond is that it defaults, which means it's worth nothing. That happened to some bonds issued by Orange County, California some years ago. Another bad thing that can happen is that the issuer "calls" a bond, meaning the issuer would prepay the bond before maturity, as a result of fallen interest rates. As an investor, you would have to get your original money back earlier than planned, and find a place to invest it.

You can buy US bonds from its website. Or you can seek higher returns by investing in a bond mutual fund that holds more corporation bonds.

Suggestions on bond mutual funds

1. Pay attention to the expense ratio of the fund. Returns on bonds are small, as compared to stocks. Management expense of the mutual fund can have a significant bite of that return.

2. High-quality corporate bonds are almost as safe as treasury bonds, and provide higher income. Consider putting 50% or more of your bond investment in high-quality corporate bonds.

3. Intermediate-term (5-10 years) bonds can provide 95% of the return with 1/3 of the investment duration, as compared to long-term bonds. You may want to invest in intermediate-term bonds to have more flexibility.

4. Mortgage-backed securities funds (issued by Ginnie Mae, Fannie Mae, or Freddie Mac) may have trouble if the interst rates go either way. When the rates go up, the funds tend to lose value, same as other bond funds. When the rates go down, people tend to re-finance their mortgage, forcing your fund to re-invest the money sooner than anticipated, and possibly at a lower interest rate.

5. Municipal bonds are designed for people in a high tax-bracket. Don't consider it if you are not. Definitely don't have it in your tax-deferred or tax-free accounts.