Bonds In Your Portfolio

U.S. government bonds does not quite guarantee returns -- but they come awfully close. Much closer than stocks, stock funds, and, of course, riskier investments, such as commodities.

It is in fact, the perfect complement to riskier investments. If your stock returns are shrinking before your eyes, you can always fall back on the certainty of your bond dividend payments. They act as a reliable safety net and effective diversifier of your portfolio.

Bonds have one job to do: Preserve capital. That's it. But sometimes they don't do it. Inflation is the culprit. If the interest you make on the bond is lower than the average rate of inflation over the life of the bond, your investment has lost you money in real-money terms. Throw in taxes, and you have lost even more money in real-money terms.

Inflation seems to be on the way up, though not drastically. The fed interest rates are also increasing . . . to keep inflation in check. Bond rates are modest. Some experts would say overvalued. You're not getting a fair market rate.

This is clearly not the best market in which to buy bonds. But since bonds should be a part of any investor's portfolio, here are three smart ways to play the bond market right now:

1. "Ladder".

Time your investments so one matures every two years. You can do that by investing in 1-, 3-, 5-, 7-, and 9-year bonds. When your 1-year bond matures, reinvest the principal in a 10-year bond. Your series of bonds will now mature in 2,4,6,8, and 10 years. Each time a bond matures, reinvest in a 10-year bond. If bond yields are getting higher, you're never more than two years away from taking advantage of those higher rates. If they're headed down, you still have several bonds invested at the higher yields.

If you ladder your investments right, you could have them set up in such a way that you would be able to support a comfortable retirement lifestyle on your maturing bonds alone. (This is something that Michael Masterson has done.)

2. Buy and hold.

Investors exhibit the same shortsighted behavior with bonds that they do with mutual stock funds. Investors should -- but typically do not -- buy and hold their bonds. And that's the only way you know for sure that you'll get your full principal back. If you sell before maturity, you risk having to discount your bond price. So plan ahead. If you're thinking of investing in a business five years from now, invest in a 5-year bond, not a 10-year bond.

3. Choose carefully.

There are 5,000 to 8,000 investment-grade bonds available to you. If you are new to bonds, I suggest you bypass corporate bonds and government bonds from agencies such as the Farm Credit Financial Assistance Corp. Invest in U.S. Treasuries instead. You can buy these bonds direct and avoid broker commissions.

Call the U.S. Bureau of Public Debt (800-722-2678) for an application or download the form online at the government's commission-free US Goverment Treasury Bonds website. Click on "about" in the upper right corner of the home page. In the second paragraph, click on the link "Electronic Services for Treasury Bills, Notes, and Bonds." Under "Self-Service Options," click on "Forms & Brochures." To get the application form, click on the "PDF" of the top form listed ("NEW ACCOUNT REQUEST").

Pay attention to these three important points and your portfolio will be in good shape. But here are some more things that you can -- and should -- do: more...