Understand the risks and rewards of bonds before investing

By Michelle Singletary

Bonds used to be boring.

Stocks were sexy. Many investors saw them as their route to an early retirement.

Of course, the recent bear market has made many people realize that bonds are the tortoises up against hare-like stocks.

Bonds may not give you as fast or as high a return as some hotshot stocks, and even pokier stocks will edge bonds out over a long period of time, but slow and steady can keep you in the race without giving you a heart attack.

Still, bonds can lose money. If you aren't careful, the bonds you buy can be riskier than you may want and cost more than you intended, according to financial planners from the Zero Alpha Group (ZAG), a network of seven national independent fee-only investment advisory firms.

"Most people think that by placing money in bonds, it's an automatic free pass," Thomas Muldowney, managing director of Savant Capital Management in Rockford, Ill., said during a news conference. "They think that there's simply no risk, and that's just not the case. When you concentrate or allocate too much money in bonds, even if you're doing it because of age, you run the risk of an increase in (the) interest rate ... stock market increases, or inflation."

Time and again Muldowney and other members of ZAG said they see investors make the same bond-investing mistakes:

• Failure to consider buying a bond index fund: "Most people don't realize that they can invest in bond index funds just like they would stock index funds, said Christopher Kerckhoff Jr., vice president of Plancorp, based in Chesterfield, Mo. "Many investors realize the power of investing in stock indexes—they're natural diversifiers, lowering risk and keeping down costs. The same is true with bond indexes." In the case of a bond index fund, professional money managers design a portfolio to match the performance of a particular broad-based bond index. For example, the Vanguard Total Market Index Fund tracks the performance of the entire U.S. investment-grade taxable bond market.

• Investing in long-term bonds when short-term might be better: "A key point to remember is the longer the term of the bond, the more its return is tied to fluctuating and potentially debilitating interest rates," Kerckhoff said. For instance, let's say you buy a 30-year bond at 3 percent interest. But 10 years into the bond, interest rates jump to 8 percent. New investors are now able to buy bonds at the higher interest rate while you're earning just 3 percent. Investors should consider short-term bonds so that if interest rates rise, they won't have to wait as long to reinvest at higher yields, ZAG recommends.

• Ignoring the taxman: Interest from bonds is taxable at your normal income tax rate. Some bonds offer special tax advantages. For example, there is no state or local income tax on the interest from U.S. Treasury bonds. There is also no federal income tax on the interest from most municipal bonds. In many cases, you also won't owe any state or local income tax, the Bond Market Association said. The decision about whether to invest in a taxable bond or a tax-exempt bond can depend on whether the bonds will be held within an account that is already tax-preferred or tax-deferred, such as a pension account, 401(k) or Individual Retirement Account. Investors in higher-income tax brackets should consider keeping their taxable bonds in a tax-deferred account, the ZAG advisers recommend.

• Chasing returns: "The late 1990s were, to say the least, volatile and risky for investors," Kerckhoff said. "People chased stocks all over the map. Some turned into gold mines. Most turned, literally, to dust. For every person who got in at the right time on a rising stock, there are four or five more who chased a stock at the wrong time." Chasing bonds to bolster portfolio performance during a volatile stock market can be just as risky as stock chasing, Kerckhoff said.

• Buying too much junk: The types of bonds you can buy range from the highest-credit-quality U.S. Treasury securities, which are backed by the full faith and credit of the U.S. government, to bonds that are below investment-grade and considered speculative (junk bonds). Since a bond may not mature for years — even decades — credit quality is important. Small individual investors need to realize that junk bonds that promise returns of 7 percent, 10 percent or more in a 1 percent or 2 percent interest rate environment are riskier because the company issuing the bond may not be financially strong. "Institutional investors often use junk bonds in their portfolio to great advantage — mainly because they are able to, by virtue of their much larger portfolios, invest in more company debt, thereby reducing their risk," Kerckhoff said. "Joe and Jane Investor are rarely so lucky. Instead, their junk investments are in essence bets that end up being much riskier endeavors."

It took a downturn in stocks for bonds to get the respect and attention they deserve. But don't rush to bonds without first understanding their role in your investment portfolio for the long term.