The risk with bonds -- also known as fixed-income investments -- is that when interest rates rise from their historic lows, bond prices can fall. Remember that bond prices move in the opposite direction of interest rates.
"The environment for the fixed-income market over the next several years is likely to be very different than the past 10 to 20 years," says Michael Sheldon, chief market strategist for RDM Financial Group in Westport, Conn.
"These are the lowest interest rates we've seen in a generation. So it's logical that rates can only go in one direction from here, namely higher."
Legend Financial recommends a short-term adjustable-rate government bond fund for some of its clients. Short-term bond prices decline less than long-term bonds when interest rates rise. Adjustable-rate bond funds can offer more stability in dividends and share price than fixed-rate bond funds. And government bonds are safer than corporate bonds.
Given the risk of higher rates, Holtzman says retirees should consider putting just a portion of their cash reserves into this type of fund. "You hear about keeping six months of your spending needs in cash reserves," he says. "Maybe put one to three months of it in a fund like that."
Treasuries, munis and corporates
A Treasury bond or Treasury bond fund will offer you the most safety in the fixed income market. Unless the federal government goes bankrupt, you can rest assured that the bond's principal and interest will be paid in full.
The second safest class of bonds and bond funds is the municipal market. These bonds come in two forms. First, there are general obligation bonds, which are repaid with general tax revenue received by the municipality.
And then there are revenue bonds, which are paid back with revenue from a specific project -- a hospital or a convention center for example. Obviously general obligation bonds are safer than revenue bonds. To compensate for the risk, revenue bonds have higher yields.
Corporate bonds and bond funds offer higher yields than Treasuries and munis, but they also present greater risk. That's because corporations can go bankrupt more easily than the government.