1. Stocks do not always outperform bonds.
Stock and bond returns were a wash from about 1870 to 1940. It
is only in the post-World War II era that stocks so widely
outpaced bonds in the total-return derby. For example, since
1950 large company stocks have returned 13.4% per year on
average vs. 5.9% for long-term U.S. Government bonds,
according to Ibbotson Associates.
2. You *can* lose money in bonds.
Bonds are not turbo-charged CDs. Though their life span and
interest payments are fixed -- thus the term "fixed-income"
investments -- their returns are not and they are subject to
a number of risks.
3. Bond prices move in the opposite direction of interest rates.
When interest rates fall, bond prices rise, and vice versa.
But if you hold a bond to maturity, price fluctuations don't
matter. You will get your principal back -- along with all the
interest you expect -- when the bond matures.
4. A bond and a bond mutual fund are totally different animals.
With a bond, you always get your interest and principal at maturity,
assuming the issuer doesn't go belly up. With a bond fund, your
return is uncertain because the fund's value fluctuates.
5. When buying individual bonds, stick with new issues when possible.
You get them wholesale. Older bonds are more dicey. They trade on
the secondary market, and their prices include a dealer's markup.
Sometimes these markups are excessive, but you will never know what
spread you are paying unless you ask -- and your broker is willing
to tell you.
6. Don't invest all your retirement money in bonds.
Inflation erodes the value of bonds' fixed interest payments. Stock
returns, by contrast, tend to keep pace with inflation. Young and
middle-aged people should put a large chunk of their money in stocks.
Even retirees should own some stocks, given that people are living
longer than they used to.
7. Consider tax-free bonds.
Tax-exempt municipal bonds yield less than taxable bonds, but they
can still be the better choice for taxable accounts. That's because
tax-frees sometimes net you more income than you'd get from taxable
bonds after taxes, provided you're in the 28% federal tax bracket
8. Pay attention to total return, not just yield.
Returns are a slippery matter in the bond world. A broker may sell
you a bond that is paying a "coupon" -- or interest rate -- of 8%.
If interest rates rise, however, and the price of the bond falls by,
say, 3%, its total return for the first year -- 8% in income less a
3% capital loss -- would be only 5%.
9. If you want capital gains, go long.
Gamblers who want to bet on the direction of interest rates should
buy long-term bonds or bond funds, especially "zeros." Reason: when
rates fall, longer-term bonds gain more in price than shorter-term
bonds. So you win big -- scoring a large potential capital gain in
addition to whatever interest the bond may be paying. If rates rise,
on the other hand, you lose big, too.
10. If you want steady income, stick with short to medium.
Investors looking for income should invest in a laddered portfolio
of short- and intermediate-term bonds. For more on laddered portfolios,
see our "Sizing up risks."
Next: Why Bonds?