Bonds and Bond Funds 101

For long-term money, it’s hard to beat the growth potential of the stock market. Still, investing in bonds for income can be smart — especially when we’re in or near retirement. Learn more about them first. For starters, know that interest rates, which have long been near record lows, have begun inching up. That’s not good news for bonds, as there’s typically an inverse relationship between bond prices and yields. If interest rates rise, the prices of existing bonds drop, and vice versa. Why? Imagine owning a bond yielding 3.5 percent. Then rates rise, and a new bond with the same terms yields 4.0 percent. If you want to sell your now-less-attractive bond, you’ll have to offer a discount to compensate for the lower yield. This isn’t necessarily a problem for investors in individual bonds. As long as you hold the bonds until maturity, the issuer should return your entire principal. If you invest in bond mutual funds, though, as many do, results can vary. In 2013, for example, interest rates moved up and the stock market surged more than 30 percent, but bonds generally lost value. Rising rates in 1994 also led to a bad bond year — and a lackluster year for stocks, too. Still, bond funds do have advantages. They offer diversification and the potential for capital appreciation, and they let you invest small amounts in bonds. If, above all, you want to preserve your principal, be wary of bond funds and consider individual bonds instead. It’s easy to invest in Treasury securities, including the inflation-indexed I Bond. Many brokerages offer government and other bonds, and you can buy government bonds at treasurydirect.gov, too, commission-free. Consider short- or intermediateterm bonds or bond funds. Longterm bonds can be more volatile, with any extra yield not worth the risk. Understand that the lower the risk, such as with government bonds, the lower the return. The highest rates are offered by risky junk bonds. Learn about alternatives for shortterm savings at fool.com/personalfinance/index.aspx and elsewhere.