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Bond investing in today's low-return world

Investing » Bond Investing In Today's Low-Return World

With U.S. interest rates near record-lows, uncertain economic growth and Europe's debt crisis roiling financial markets, it's a tricky time to invest in bonds.

"This is a challenging period for fixed-income investors because the Federal Reserve is keeping short-term interest rates extremely low," says Michael Sheldon, chief market strategist for RDM Financial Group in Westport, Conn. "Interest rates have been declining for more than 30 years. That's been a positive tailwind for investors. Eventually rates will start going up, and that will represent a headwind for investors."

There's currently tension in the bond market among the factors moving prices. "There's a tug of war between (two questions): Are interest rates headed higher, or do we have to be concerned about slow global growth and the euro crisis?" says Miriam Sjoblom, associate director of fixed-income analysis for Morningstar research in Chicago.

Higher rates by definition mean lower bond prices, while slow economic growth depresses rates and pushes bond prices higher. The euro crisis has pushed rates down as investors flock to Treasuries as a safe haven.

The tug of war "shows how difficult it is to call the market and (reemphasizes) the need for a diversified portfolio, even with yields as low as they are," Sjoblom says.

She and other experts have several ideas about how to approach bond investing in this difficult environment. It may be easiest to grasp these ideas by looking at the main sectors of the bond market -- Treasuries, investment-grade corporate bonds, high-yield or junk bonds, municipal bonds, and foreign bonds.

But three issues bear discussion first: buying individual bonds versus bond funds, credit and interest-rate risk, and maturities.

Bonds versus funds

As for which of the two to purchase, the call is easy, experts say. Unless you have at least $250,000 to invest, stick with funds. That's because individual bonds are very expensive. And you don't even know what the commission is because brokers simply bake it into the price of the bond.

So you have to make a bond purchase of about $50,000 just to keep the commission from becoming exorbitant. And some bonds don't have much liquidity, making them difficult and expensive to sell.

An exception to this rule is Treasuries, which you can buy directly from the government for no fee with a minimum purchase of only $100. For more information, see TreasuryDirect.gov.

Bond funds do have one major disadvantage over individual bonds. When interest rates rise, the value of bond funds will fall. The value of individual bonds will fall, too. But as long as an individual bond doesn't default, you can simply hold it until maturity and get the bond's full principal back. Bond funds have no maturity, so there is no guarantee of how much money you will receive when you sell it.

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Credit and interest-rate risk

Credit and interest-rate risks are the two kinds bonds carry. Credit risk refers to the possibility the bond issuer won't be able to meet interest or principal payments. Credit risk is virtually zero for Treasuries but very high for some junk bonds.

Interest-rate risk is the risk that rates will rise in general. That usually stems from strong economic growth, high inflation and/or short-term rate increases by the Federal Reserve.

Maturities

Bonds with longer maturities generally have higher interest rates than short-term bonds, but long bonds fall further when rates rise. Legend Financial Advisors has clients who have invested in bond funds that hold 20-year and 30-year Treasuries, says Jim Holtzman, a shareholder at the Pittsburgh-based firm. If interest rates rise 1 percent, the prices for those bonds will drop 20 percent, he says.

So what happens in the different sectors?

Treasuries

"Treasuries pose the biggest risk," says Tim Ghriskey, chief investment officer of Solaris Asset Management LLC in Bedford Hills, N.Y. "They move the most when the Fed changes policy, and they anticipate the change as well."

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