Bonds are usually considered the safe portion of an investment portfolio. But investing in bonds can yield some unpleasant surprises.

The bond market has dynamic quirks of its own and can require sophisticated investment strategies, particularly in today’s interest rate environment.

Bond fund or individual bonds?

The bond market is extensive. Institutions of all kinds issue bonds to raise money. The easiest for individuals to buy are Treasury securities. Investors can go to TreasuryDirect.gov and buy Treasury bills, bonds or notes directly.

It gets a little more complicated to buy bonds issued by businesses, local governments or private institutions.

Retail investors compete against institutional investors as well as investment professionals who buy large lots of bonds for their clients. That means the best bonds may never be seen by individuals. And if they are seen, the price may not be as good as it is for people buying larger quantities, and trade execution can be a little slower.

“When I see a good bond now, I have about four seconds to hit the buy ticket or it’s gone. That means the retail investor is going to be buying the issues that nobody wants to buy,” says Bill Larkin, fixed-income portfolio manager at Cabot Money Management in Salem, Mass.

Though that’s not always the case, investors should be aware the deck may be stacked against them.

Buying individual bonds allows investors more control over their investments, but as with individual stocks, their investment portfolios need to be sufficiently large to accommodate the number of bonds necessary for proper diversification.

Herbert Hopwood, president of Hopwood Financial Services in Great Falls, Va., stocks his clients’ portfolios with 20 to 30 individual bonds of differing issuers, sectors and maturities.

“You have to be very careful about saying, ‘I’m going to only buy one bond, and it’s going to be a big part of my portfolio.’ The idea is that you want some diversification. I would suggest looking at corporate bonds — 10 different issuers at least. If someone has $50,000 to do this, they may be better served by using a bond fund,” he says.

Attributes of bond funds

The disadvantage of bond funds is their ongoing fluctuation in price. Whereas a highly rated individual bond purchased at par value can be held to maturity with no apparent loss of principal, bond funds, which constantly buy and sell bonds, are priced daily. This means they’re subject to price fluctuation, and investors can lose money.

An investor who holds an individual bond to maturity can ignore all price changes that would affect selling the bond on the secondary market. Barring default, the investor will receive the face value at maturity.

Rising interest rates can also negatively affect the price of the bonds in a fund. As interest rates go up, so will the coupon rate on newly issued bonds. The price of existing bonds will fall because their interest rates are lower, so investors are compensated for the discrepancy when they purchase those bonds at a discount.

The prospect of high turnover is one argument against getting into a bond fund today. Following a stampede into bond funds can backfire when the stampede heads out.

According to the Investment Company Institute, a national association of investment companies, bond funds have experienced a steady influx of billions of dollars per month since January 2009, while money has steadily trickled out of equity funds.

When inflation, and therefore interest rate, expectations change, “the market is going to anticipate the change,” says Larkin. “The money that is in the bond market is scared money. It’s worried about losing money and apt to flee.”

When bond fund investors flee en masse, fund managers without an adequate reserve of cash must sell bonds to meet redemptions.

“If you’re in a corporate bond fund that is having large redemptions, that means they’re selling bonds at not-attractive rates when the market turns against them,” he says.

Diversified approach to reduce risk

As is the case with equities, trying to time the bond market doesn’t always work in favor of investors. One stress-free way to get into the bond market is with dollar-cost averaging and a diversified strategy.

Bonds with long maturities are more impacted by rising interest rates than short-term bonds. To reduce interest rate risk, Robert Laura, partner at Synergos Financial Group in Howell, Mich., recommends funds with maturities of less than three years.

“Since we don’t know what is going to happen, we’ve been playing all the angles,” Laura says. “We’ll go with a high-yield bond fund because if interest rates don’t move for two years, it’s a great place to be and you’re earning a great yield. There has been a lot of discussion about a bond bubble, but bonds in general and high yield bond funds are doing well because interest rates have stayed so low.”

Laura says he also includes Treasury Inflation-Protected Securities bond funds in case rates do rise and inflation sprouts up.

Whatever strategy an investor chooses, the universe of bond funds is huge, so investors without the means or motivation to buy individual bonds have much to choose from.

Bill Larkin recommends investors explore multisector bond funds in the current environment. These funds typically invest in different types of bonds as well as varying maturities.

“I call it unrestricted investment objective. They’re going to be zigging and zagging, trying to find value. People always forget that the bond market is vast and there is always a part of it on sale — you just have to find the right parts,” Larkin says.

In this challenging economic environment, paying investment professionals to find the best bonds can be worth the cost, whether that means buying a bond fund or enlisting the services of a good financial adviser.

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