Before you invest in bonds, evaluate your financial situation and devise a plan that best suits your goals. Decide what you want from your investments; are you looking for income, safety, or growth? Once you have made your decision, research the market for bonds based on the following criteria: credit risk, interest rate risk, and expenses.

Treasury Bonds

If you are looking for safety, then you might want to invest in treasury bonds. They are considered safe because they are backed by the U.S. Treasury. Treasury bonds run virtually no risk of default and you are guaranteed your interest payment and the return of your principal.

Some Drawbacks of Investing in Treasury Bonds

Treasury bonds do have some disadvantages. They are susceptible to inflation and their value decreases as inflation rises. For example, if the interest rate of a treasury bond is 4.5 percent and inflation rises to 5 percent, then the value or price of your principal actually decreases if you were to sell the bond immediately. By the time you get your principal back, it will not be worth as much.

Bonds have an inverse relationship with interest rates. If interest rates rise, then the price of the bond declines. When you buy a bond, you are locked in at the interest rate at which you bought it. So, if you decide to sell the bond before it matures and interest rates rise, then the value or price of your bond will decline.

Finally, treasury bonds pay low interest rates. Other forms of investment could get you a higher rate of return, but they can be riskier. If you are risk averse, then treasury bonds may be a better fit for you.

Money Market Funds

The most common form of bond investing is the money market fund. Money market funds are considered safe because they are liquid.

                                                                       
The liquidity of these bonds is attractive to investors who want to save money for a short period of time, because it allows them to withdraw cash whenever they need it. Someone who is planning to buy a house may want to invest in a money market fund.

Although money market funds are safe, they do not offer high returns to investors. However, these funds are known as a great way for investors to “park” their cash for a short time. For example, an investor who has just received a bonus may put the money into a market money fund until he decides how he wants to invest the cash.

Bond Funds

Treasury bond funds invest in bonds issued by the U.S. Treasury and offer diversification. They are not the same as individual bonds. While an individual bond gives the investor his principal and interest at maturity, a bond fund is less certain because it does not have a fixed maturity. This means that the interest payment on the fund and its price per share can fluctuate.

Bond funds also allow the investor to sell shares of the fund at any time. However, bond funds do have annual costs which can decrease your yield of return. Be sure to screen for funds with low expenses.

Municipal and Corporate Bonds

Depending on your tax bracket, it may be advantageous to invest in tax-free municipal bonds. If you belong to the 28 percent federal tax bracket or higher, a tax-free bond can earn you more profit than a taxable bond after all taxes are paid.

Corporate bonds pay a higher interest rate than treasury bonds. They are graded on their creditworthiness and the likelihood that the company issuing them will not default. Creditworthy bonds have a rating of AA or AAA. Bonds with low credit ratings are called “junk bonds.” They pay higher yields because they carry more risks.

Capital Gains

Investors hoping to earn capital gains may purchase long term bonds while interest rates are high. Because bonds have an inverse relation with interest rates, the price of these bonds will rise when interest rates fall, giving the investor capital gains plus interest. This method of investing in bonds is risky, as the investor can lose a great deal of money should interest rates rise. 

Steady Income

For constant and steady income, you should stick with short to intermediate term issues which mature from two to seven years. Intermediate terms yield higher returns than short term bonds and are less volatile than long term bonds. 

Diversify

Just like stocks, it is a good idea to diversify bond investments. The safest way to invest in bonds is to diversify your bond portfolio based on maturity and issuer. Bonds are a great way to balance your investment portfolio because they can help offset stock losses incurred during a bear market.

Additional Resources:

• Morning Star Web site:                          www.morningstar.com
• CNN Money Central Web site:                www.money.cnn.com
• FINRA Web site:                                   www.finra.org