What are the advantages of bonds?
First and foremost, bonds provide investors with a way to diversify their portfolio and help protect themselves from market swings. Different asset classes might respond differently to economic conditions, and bonds may do well when other types of investments—such as stocks and real estate—fall, which could potentially provide a safety net over time.
When you buy a bond, you're essentially lending money to the entity that issued it, and you're betting they'll pay you back as promised. If your bonds are highly rated—i.e., the ratings issuers believe the entity is financially strong enough to repay the debt—they are generally considered a lower risk.
Because bond issuers are repaying debt over time, bonds can also provide steady income, which can be a real benefit if you're looking for a predictable stream of money—for instance, to help with living expenses in retirement. Municipal bonds (issued by a state, city or county) can even provide a tax-free income stream. Remember, bonds are not guaranteed investments and it is possible to lose money investing in securities.
What are the disadvantages of bonds?
Although bonds provide diversification, holding too much of your portfolio in this type of investment might be too conservative an approach. The trade-off you get with the stability of bonds is you will likely receive lower returns overall, historically, than stocks. Hence, the percentage of bonds in your investment strategy depends on how much growth potential you're seeking over time.
How much should you invest in bonds?
As with any investment, diversification is key, even among bonds. Consider funds that allow you to buy a collection of bonds in different categories, such as municipal bonds, international bonds and high-yield bonds. Spreading your funds among these can help protect your nest egg. Different categories do well at different times and carry different levels of overall risk, so owning a variety of investment types could help you hedge your bets against under performance.
How to invest in bonds
In a bond fund, a fund manager can buy and sell bonds as they mature or as prices fluctuate. This kind of flexibility is important when interest rates rise, because an older bond paying 2% interest isn't as attractive as a newer bond paying 2.5% interest. Bond prices also fall when interest rates go up, so you can lose money if you sell your bond before the maturity date.
In a bond fund, you're not locked into a bond with a lower rate, nor are you trying to sell individual bonds on the open market, which can be trickier.
The other advantage of a bond fund is that interest payments can be automatically reinvested, which tends to lead to growth over time. All that said, bond funds aren't a guarantee—they can diminish in value, particularly in the short term, and investors can lose money, just as with stock funds. It's wise to research your bond investments as thoroughly as you do the stock portion of your portfolio.