Investing Basics:
How to Invest in Bonds

The best approach most advisors recommend is to diversify your holdings between stocks, cash, and bonds.

Bonds have the advantage of predictability, and are a reliable and secure source of future income. If you're looking for big returns, then you probably won't want to put a large percentage of your assets into the bond market. The stock market delivers more potential for large gains--although it also has the same downside. Bonds aren't used for aggressive wealth-building, but may be very useful as part of a retirement strategy where something more dependable is more desirable.

You can purchase government bonds through a Treasury Direct program, which carries no fees if your account is less than $100,000. There are bond mutual funds available, but the fees incurred from participating often make these less desirable unless you require more liquidity in your investments. Investing in government bonds does not take a lot of complicated analysis, and unlike stocks and other equities, armchair investors can do just as well on their own as opposed to through a fund.

Government bonds aren't the only type of bonds, however. The federal government issues bonds to raise money, but corporations can also do that, as well as local municipalities. Corporate and municipal bonds may have a higher degree of risk, but will provide a higher rate of return than the ultra-secure Treasury bonds. If you're interested in corporate or "muni" bonds, a mutual fund may be more appropriate as a way to test the waters, because of the complexities involved and the fact that there are often high commissions and larger spreads between the bid and ask prices when buying directly. And although there's virtually no risk with a Treasury bond, check the rating of any other municipal or corporate bond you choose to invest in. A lower rating may yield a higher return, but the risk will be substantially greater.

When considering corporate bonds, consider the yield plus the commission and fee structure. A corporate bond will pay higher than a Treasury bond, but the management fee will lower your effective yield, sometimes making high-grade corporate bonds pay less on the bottom line than no-risk T-bills.  Also take into account the favorable tax treatment you may receive by investing in Treasury or municipal bonds, which makes your effective yield greater than it seems.

For those who choose to invest in municipal bonds, consider spreading your risk. Buying municipal bonds from within your own state will often give you a state tax break, but if your state's economy declines, then all of your muni bonds may be in trouble. You can mitigate local economic risks by investing in munis from several different regions. A second strategy in general is to stagger your investments to spread out maturity dates and coupons, so that money comes due every few years.

Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.