2011 Interest Rate Forecast » Don't bond with bonds, some experts advise

After limping out of the Great Recession, seemingly everyone has a stake in seeing the American economy gain traction in 2011.

But it is precisely the prospect of an expanding economy that could harm one notable niche of interest-dependent investors: bond holders.

The problem is that an improving economy would likely mean a pickup in inflation and, ultimately, higher interest rates. Existing bonds, with lower fixed rates, would be less attractive.

Investors would still get their regular interest payments -- that's why bonds are known as a fixed-income investment. But the value of the bond itself would decline, producing a loss if you had to sell before maturity.

That cuts to the central truth about bonds: Bond prices move inversely to yields. If rates start to rise, the value of existing bonds will go down. (Unlike stocks, bonds aren't traded on exchanges. Generally, you must use a dealer to buy or sell them.)

That's not to cause panic. Experts aren't predicting sharply rising interest rates in 2011. Then again, it may not take much to cause problems.

"With interest rates as low as they are, deficits and government borrowing as high as it is, it wouldn't take much on the inflation front to unleash a real rout in the bond market," says Greg McBride, Bankrate's senior financial analyst.

Bill Larkin, fixed-income portfolio manager at Cabot Money Management in Salem, Mass., agrees. Cash "might be the best fixed-income investment possible in 2011," despite rock-bottom returns on CDs and savings accounts, he says.

Ways to bond

Diversification across many types of bonds will reduce, but not eliminate, interest rate risk. Types of bonds available to investors include corporate bonds, Treasury securities, municipal bonds and agency bonds. Investors can buy individual bonds or they can invest in mutual funds that specialize in them.

Corporate bonds are issued by companies. Essentially, investors lend the company money and receive interest payments for a set number of years. The bonds are redeemed at original face value at maturity. Corporate bonds range from very safe to highly risky.

The U.S. Treasury also issues bonds. Federal debt securities run from very short-term Treasury bills to intermediate Treasury notes of up to 10 years and Treasury bonds that mature in 30 years. They're backed by the U.S. government and considered to be among the safest investments in the world.

Two other types of bonds are municipal and agency. They're issued by state and local governments, government agencies and government-sponsored enterprises.

From a financial planning standpoint, interest from corporate bonds, agency bonds and Treasuries is taxable on the federal level. Interest from municipal bonds, on the other hand, is free from federal taxes. This enhances municipal bonds' appeal.

Holding a bond to maturity negates some interest rate risk because you get your principal back at maturity, no matter if it was worth below face value in the interim. But if inflation has surged in those years, your original investment will have lost purchasing power.