A brief introduction to bond investing

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

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NEW YORK (Money) -- Question: I'm 26 and want to set up a diversified portfolio for retirement. I'm almost totally invested in stocks, but I know that I should put some money into bonds. I really don't understand how they work, however, and I don't feel comfortable investing in something I don't understand. For example, I think I get the basic idea of a bond, but when I see bond yields fluctuate, I get confused. Aren't they supposed to have a consistent interest rate? --John, Portchester, New York

Answer: Ah, the mysteries of the bond market! I can understand why you might be a bit perplexed. After all, bonds are referred to as "fixed income" securities, but as you note, their yields constantly shift.

But in fact bonds aren't all that confounding once you understand a few principles. So let's do quick overview of bond fundamentals, and then talk about how you can (and should) incorporate bonds into your retirement investing plan.

The simplest way to envision how bonds work is to think back to your days as a toddler at the playground. Remember the seesaw? Well, bonds operate a lot like a seesaw. On one side are bond prices, on the other side are bond yields, or interest rates. When bond prices go up, yields go down. When bond prices fall, yields go up. The farther out toward the edge of the seesaw you are -- or the longer the time until the bond's maturity date when its face value is repaid -- the more yields, or interest rates, move up and down as bond prices rise or fall.

Prices and yields

So why is there this inverse relationship between bond prices and interest rates or yields? Let's say you buy a newly issued 30-year $1,000 Treasury bond with a coupon interest rate of 4.25%. Unless the U.S. Treasury goes broke, you'll receive $42.50 in interest payments each year on your bond for 30 years, and then get your principal back.

But let's suppose that soon after you buy your bond, investors get worried that the inflation rate will rise. If that happens, the coupon rate on newly issued 30-year bonds will go up, as investors will want larger payments to compensate for higher inflation, which further erodes the purchasing power of the interest payments they'll receive in the future. I'm not making a prediction here, but, just for the sake of this example, let's say the rate on 30-year Treasuries goes to 5%.

And let's also assume you then want to sell your Treasury bond. Do you think you can get $1,000 for it? Of course not. No one would pay you $1,000 for a 30-year Treasury paying $42.50 a year when he or she can get a new one with a 5% coupon paying $50.

You can't change the coupon rate on the bond. That's fixed, as well as the $42.50 payment (hence the "fixed-income" moniker). But the price can change. And to attract an investor willing to buy the bond, its price would have to drop, pushing its yield above the coupon rate.

The price would have to fall low enough to compensate the investor for the lower payments. The longer the term of the bond, the more the price has to drop since an investor is locked into those lower payments for a longer time. You don't have to figure out the bond's price on your own. The interaction of buyers and sellers in the bond market will do that for you.

The point is, though, that while a bond's coupon rate remains the same -- as does the amount it pays out each year -- the percentage yield that an investor buying that bond based on its market value or selling price at any given time can and does change daily, as you've noticed. You can track the ups and downs of yields by going to the Bonds section of our site.

The risks

When you invest in bonds, you take on two types of risk: credit risk and interest-rate risk. Credit risk is simply the chance that the bond issuer won't make the scheduled interest payments and repay principal. That's not a factor with Treasury bonds, but it can be with corporate bonds, particularly with high-yield or junk bonds.

Interest-rate risk, on the other hand, refers to the possibility that your bond may lose value if interest rates rise after you buy it. (Of course, it can also gain value if interest rates fall.)

You can protect yourself against credit risk somewhat by sticking to high-quality bonds and by holding many bonds instead of just one. You can mitigate interest-rate risk by investing in bonds with short- to intermediate maturities or terms (in other words, by not going too far out on the seesaw).

Bonds in your retirement portfolio

Well, even though you're a mere youngster with decades to go before you reach retirement, I think it's a good idea to put a small portion of your portfolio -- say, 10% to 20% -- into bonds.

Bonds can smooth out some of the ups and downs in the value of your portfolio, as bond prices aren't as jumpy as stock prices. Also, while I fully expect stocks will outperform bonds over the long haul, it never hurts to hedge your bets a bit.

As for how to include bonds in your retirement portfolio, there are many ways to go. You can buy individual bonds or bond funds, Treasurys or corporates, or some combination of these.

But I think the best approach for most people is to invest in a total bond market index fund like the one we include in our Money 70 list of recommended funds. This type of fund gives you the entire U.S. investment-grade taxable bond market in one shot -- Treasuries, government mortgage-backed bonds, corporate bonds, the whole shebang. And it has an average maturity of six to seven years, right in the intermediate-term sweet spot.

Which means you're getting the benefit of bonds without taking on undue credit or interest-rate risk. Oh, and since it's an index fund, the fees are easy on the wallet too.

Of course, you can get fancier if you like, adding foreign bonds, high-yield issues, TIPS (Treasury Inflation-Protected Securities) not to mention other varieties. But be careful. While simple in concept, bonds can get tricky and some can be quite volatile: witness the fact that high-yield bonds lost nearly 27% last year.

Truth is, I've only scratched the surface on this topic. You can learn lots more by checking out our Money 101 lesson on bonds and by visiting Investing in Bonds and the Bonds section of The American Association of Individual Investors' site.

But if nothing else, I hope you now feel comfortable enough to begin diversifying your portfolio into bonds.