Key Points

Bonds and bond mutual funds offer a sound way to add diversification to a
long-term investment portfolio and help generate a steady stream of income. But
even fixed-income investments -- generally considered less volatile than stocks
-- pose an element of risk. Understanding the different types of risks can help
you manage your portfolio's downside exposure and enhance your potential for
income.

Generally, there are two reasons for considering investments in bonds:
diversification and income. Bond performance does not typically move in tandem
with stock performance, so, for example, a downturn in the stock market may be
offset by increased demand for bonds. Some investors view the bond market as a
safer haven for their money during periods of stock market uncertainty. Bonds
also offer the potential for higher income than more conservative investments
like money market mutual funds.

Essentially, a bond represents a loan to a corporation, municipality, or
government agency. For lending them money, bond issuers promise to pay the
bondholder a specific amount of interest, usually quarterly or semiannually,
and repay the full amount of principal on the maturity date. The level of
income potential depends on several factors, including the type of bond and tax
classification. In addition to the potential rewards, bond investors should be
aware of the risks, including credit, market, interest rate, reinvestment, and
call risk.

Credit risk refers to the possibility that a bond issuer will default on a
payment before a bond reaches maturity. To help investors make informed
decisions, independent firms such as Moody's Investors Service and Standard
& Poor's publish credit-quality ratings for thousands of bonds. The upside
of a poor rating is greater reward potential. Issuers of lower-rated bonds
usually reward investors with higher yield potential for accepting the
relatively greater risks. As a rule of thumb, bonds issued by corporations or
municipalities with a triple-B rating or higher are called investment-grade
bonds. Non-investment-grade bonds, with ratings as low as D, are sometimes
referred to as junk or high-yield bonds because of the higher interest rates
they must pay to attract investors.

If an investor is unable to hold an individual bond through maturity -- when
full principal becomes due -- market risk comes into play. If a bond's price
has fallen since acquisition, the investor will lose part of his or her
principal at sale. To help mitigate exposure to market risk, investors should
evaluate their overall cash flow projections and fixed expenses between the
time they plan to purchase a bond and its maturity date.

Bond prices tend to drop when interest rates rise, and vice versa. This
inverse relationship is referred to as interest rate risk, which may be a
particular concern to investors who don't plan to hold a bond to maturity. A
premature sale while rates are rising could result in a loss of principal.
Exposure to interest rate risk increases with the length of a bond's maturity.
Issuers generally pay higher yields on longer-term bonds than on those with
shorter maturities.

A low interest rate environment also exposes bondholders to call risk, the
right of an issuer to redeem a bond before its stated maturity. Issuers
typically call bonds when interest rates drop, allowing them to pay off
higher-cost debt and issue new bonds at a lower rate. Bonds paying higher
yields are most susceptible to call risk. Changes in interest rates also may
give rise to reinvestment risk -- the chance that an investor may not be able
to reinvest at the same level of return and risk.

Inflation risk is the danger that the income produced by a bond investment will
fall short of the current rate of inflation. (For example, if your fixed-income
investment is yielding 3% during a period of 4% inflation, your income is not
keeping pace.) The comparatively low returns of high-quality bonds such as U.S.
government securities are particularly susceptible to inflation risk.

To counter the risk of inflation, individuals can purchase
inflation-protected government securities and bonds convertible into stock.
Inflation-protected securities include 10-year Treasury notes whose redemption
value is subject to adjustment every six months based on changes in the
Consumer Price Index. Because of the inflation-protection feature, the interest
paid on the notes is likely to be less than that paid on fixed-rate 10-year
Treasury notes issued at the same time.

Convertible bonds offer the holder the option to exchange the bond for a
specified number of shares of the company's common stock. In return for the
ability to share in possible appreciation of its stock, the bond issuer offers
a lower rate than those available on nonconvertible bonds.

Other risk management approaches are more likely to suit investors with
substantial income-producing assets. Laddering is one such strategy to help
smooth out the effects of interest rate fluctuations. "Laddering"
involves setting up a portfolio of bonds with varying maturity dates ranging
from shorter to longer term. For example, you might purchase equal amounts of
Treasury issues maturing in one, three, five, seven, and nine years, giving you
an average maturity of five years. As the principal comes due every two years,
you would reinvest that amount in Treasuries due to mature in 10 years,
preserving the five-year average maturity. Such a rolling portfolio not only
helps to limit reinvestment risk, its staggered maturities provide liquidity at
specific intervals without having to sell into the market.

Another strategy is to construct a "barbell" in which a portfolio is
invested primarily in short- and long-term bonds with few intermediate maturities.
In theory, the barbell structure allows the longer-term portion of the
portfolio to take advantage of higher yields while the shorter-term portion
limits risk. Some sophisticated investors also employ hedging vehicles such as
options and futures to help protect against loss of value due to market risk.

In addition to maintaining a diversified portfolio, investors may want to
consider insured bonds -- typically municipal bonds whose issuer has bought
insurance to pay off bondholders in the event of default. Similarly, investors
can manage call risk by knowing each bond's first call date and avoiding bonds
with call dates in the near future, especially if interest rates are falling.

Of course, not everyone has the time or knowledge to manage a portfolio of
individual bonds. With so many bond options to choose from -- Treasury, federal
agency, municipal, corporate, and mortgage, among them -- and with individual
bonds requiring initial investments ranging from $1,000 to more than $25,000,
many investors opt for the ease of bond mutual funds. Bond mutual funds offer
instant diversification, professional management, and daily liquidity. However,
bond funds may also trigger taxable events.

The bond market provides a wealth of fixed-income products to suit virtually
every investment goal and risk level. Online resources such as the Bond Market
Association's www.investinginbonds.com Web site can aid research. Still,
choosing bond investments that pursue your specific financial needs often isn't
easy, and the assistance of investment and tax professionals is advisable when
managing the risk and reward potential of your bond investments.

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© 2011 McGraw-Hill
Financial Communications. All rights reserved.

August 2011 — This column is provided through the
Financial Planning Association, the membership organization for the financial
planning community, and is brought to you by Ronald J VanSurksum, CFP®  , a local member of FPA.