Bond investing in today's low-return world
Given that short-term interest rates now stand at almost zero, the next move by the Fed will be to raise them. "That's something individual investors should prepare for within the next two to three years," Ghriskey says.
To be sure, Treasuries are safest when investing in bonds and have enjoyed strong rallies since the financial crisis. "But yields are so low that you have to question if it's worth the investment," he says.
Investment-grade corporate bonds
Despite the low interest rate environment, there are some corporate bonds that offer attractive yields, says Morningstar's Sjoblom. "The U.S. government has fiscal issues, but corporate America has done a great job of cleaning up its balance sheets. On the credit side, fund managers are very optimistic about corporates. But do they offer enough compensation?"
Ghriskey expects corporate bonds to benefit from stronger U.S. economic growth, which would boost corporate fortunes. "We like corporates but are cautious about long-term corporate bonds because they carry more interest-rate risk. We're concentrating on intermediates," he says.
Legend Financial Advisors prefers high-yield bond funds over investment-grade funds because of the yield advantage, Holtzman says. With default rates so low for the low-rated companies that issue high-yield bonds, "You're not taking a lot of credit risk."
But he notes that junk bonds correlate very closely with stocks. So if equities fall, junk bonds likely will, too. And while default rates are very low now, "If economic growth stays slow, there could be default/credit troubles ahead for lower credit-quality companies," Sjoblom says. "You can't have much better fundamentals than now. Investors should keep that in mind."
Municipal bonds are free of federal taxes -- state taxes, too, if you live in the state of issuance. So munis are particularly appealing to people in high tax brackets. Investors anticipating tax increases next year have played a big role in the strong rally for munis recently, Ghriskey says.
"But we don't think it's wise to pay for that currently, especially when we see improvement in the domestic economy and interest rate risk on all bonds," Ghriskey says.
Sjoblom says that while those investing in bonds are piling into munis now, "Investors have been doing a poor job of timing moves in and out of the market," Sjoblom says. "There is no way that returns can continue like this with yields so low."
Several cities have declared bankruptcy over the past few years, adding an element of risk to the market. But most experts say the risk is manageable and that a wave of additional bankruptcies isn't coming.
A number of foreign markets offer higher yields and better principal protection than the U.S., Ghriskey says. Many investors are looking to emerging markets such as China and Brazil. Fund managers investing in foreign bonds there point to stronger economic growth than in the developed world and prudent fiscal and monetary policy, Sjoblom says. "But keep in mind that yields already are low in higher quality markets."
Be careful when investing in eurozone bonds, especially in the southern nations, as their economies are struggling.
Also check to see if the fund invests in local currency or dollar-denominated bonds. If it's local currency bonds and the fund doesn't hedge its currency exposure, you will be at risk of a loss if the currency of a bond in the fund falls against the dollar. As a shareholder, that will help you when the currency rises against the dollar but hurt you when it falls.
Given all the crosscurrents in the bond market now, you may want to invest in funds that, together, include all these sectors. All the uncertainty "shows how difficult it is to call the market and the need for a diversified portfolio, even with yields as low as they are today," Sjoblom says.