Basics of Investing in Bonds

A balanced retirement portfolio usually contains some exposure to bonds in the form of a bond mutual fund. I found this article on bond mutual funds written by David Pitt, it gives good basic information for consideration.
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The type of bond fund you choose depends in large part on your financial goal. You need to first ask yourself whether you're seeking safety with little growth or more robust growth at higher risk. While they are safer investments, it's a mistake to think that bond funds are entirely without risk. Government bond funds, for example, have performed very well compared to other stocks and bonds this year and are considered relatively safe investments.

A Morningstar analysis shows that year to date, short-term government bond funds have earned an average of 2.6 percent and long-term government bond funds, averaged a 1.9 percent gain. In the same time frame the various categories of domestic stock funds have lost on average between 27 percent and 55 percent year-to-date. What's more, investors who earlier this year moved from equity funds into bond funds -- which have significant holdings in corporate bonds -- were able to stem some of their losses. Short-term bond funds are down 4.1 percent and long-term bond funds are down 11.5 percent so far this year.

So, you need to decide how much risk you're willing to take to determine which type of bond fund you want to choose as part of your portfolio. Fidelity Investments offers tips on how to choose bond funds.

If you're planning on investing for a year or less, a short-term bond fund may give you a better return than a money-market fund but you must be willing to see your investment fluctuate daily with market conditions. If you have more time to invest and a desire to earn more, you may want to look at intermediate- or long-term bond funds. These funds invest more heavily in higher yielding, lower-quality corporate bonds, which are higher risk. All of these choices require you to know your risk level, which may have changed with double-digit losses in your retirement account. If you can't stand losing some of the money you put into your account, many financial advisers would say a money-market fund might be your best option.

If you can tolerate losing some of your initial money and are willing to trade a little risk for higher reward, then an investment grade bond fund might work for you. The key to investing for retirement even now is not to panic and have a plan, said Jack Thurman, president of BKD Wealth Advisors, a Springfield, Mo.-based wealth management company. Unless you're within a few years of retirement, he said you should have one year's worth of expenses in savings outside your retirement account and the rest should be invested to earn as much as possible.

Millions of workers, scared by the falling stock market have taken their money out of stocks and stock mutual funds. TrimTabs Investment Research, which tracks the flow of money in and out of various funds, said through early November stock mutual funds have seen an outflow of $145 billion and international funds have shed $73.5 billion while bond mutual funds have seen an inflow of $83.2 billion over the same period.

Though the talk is of a deep recession, market watchers are increasingly discussing whether now is a good time to buy stocks because prices are so depressed. Of course the potential length of the recession is unclear, but if you're in this age group, you don't want to be on the sidelines with cash when the market surges upward. Once stocks begin to regain their strength, recovery can happen fairly quickly and if you're retirement plan is properly allocated -- many advisers recommend 60 percent in diverse stock funds and 40 percent in bonds -- you should take advantage of the upside. If you're just a few years from retirement you should have a conservative asset allocation. That means heavier investment in bonds and fewer stocks. If possible, resist the temptation to take more money out of the stock market because you'll probably need to take advantage of the market improvements to recover some of your losses.
Keep in mind that bond prices typically react opposite interest rates. When interest rates go up, bond prices likely fall and falling interest rates send bond prices higher. The current environment has also shown that bond issuers can default and fail to make payments.

One of the drawbacks to bond funds is that they may fail to keep up with inflation and therefore are often used in combination with higher yielding funds to offer portfolio balance. Fidelity advisers say it's a good idea to look at the quality of the bonds in the fund, whether they are investment grade or junk status. Those rated below investment grade (S&P rating of BB or lower) could change more suddenly if the credit quality of the issuer changes.
One more thing to look at is the expense ratio.

Morningstar says its more important to look at the cost of a bond fund, because bonds earn less over time than stock funds they're costs are a heavier burden. Morningstar believes very good bond funds are available with expense ratios of 0.75 percent or less.