Understand how bonds work ?

Walter Updegrave from CNNMoney explains bonds in a simple to understand fashion.

Question:
I'm 71 years old and retired. I know I should have some of my portfolio in bonds, but I'm not very savvy about bonds. Is now a good time to buy into bonds and, if so, what type should I buy? - Norman, Atlanta, Georgia

Answer:
Okay, Norman, I'm going to give you the world's fastest primer on bonds. Ready, here it is: You know how a seesaw works, right? One side goes up, the other down. Well, the seesaw concept is the single most important thing you need to know about bonds.

On one side of the bond seesaw are interest rates. On the other are bond prices. When interest rates go up, bond prices go down. When interest rates go down, bond prices go up.

And the farther toward the end of the seesaw you are - that is, the longer the maturity date before the bond's principal is repaid - the more the price of the bond moves up or down when interest rates change. That's it. End of primer. That is the most important thing you need to understand.

Oh sure, there are other features of bonds that are good to know about, such as credit quality. The more you stick to bonds with higher ratings from firms like Standard & Poor's and Moody's Investors Service, the less "credit risk" you'll bear - which means the lower the odds the bond issuer will default on repayment of principal and interest. (You can learn more about credit quality and other aspects of bonds, by going to our Money 101 Lesson on bonds.)

But as long as you invest in a diversified portfolio of bonds - which in the case of most individuals like yourself means buying bond mutual funds - the main danger you face in owning bonds is interest-rate risk, or the possibility that the value of your bonds will fall when interest rates rise.

So how do you manage that risk? Well, you could try to time your moves in and out of bonds, jumping in when it appears interest rates are likely to fall and bailing out when rates seem likely to rise.

But unless you're clairvoyant, I don't think you're likely to pull off such a feat. Indeed, reading the future direction of interest rates is tough even for accomplished pros, witness the fact that the Pimco Total Return fund, which is run by Bill Gross, one of the savviest bond gurus around, is now languishing at the bottom of the performance charts for the past year.

Instead of engaging in a vain attempt to guess where rates are headed, I recommend that investors adopt a simpler approach - namely, just go with bond funds with short- to intermediate-term average maturities.

Basically, that means funds with portfolios of bonds that mature on average within roughly two to eight years. There are no guarantees, of course, but history shows that intermediate-term bonds typically give you 80 percent or so of the gains of longer-term bonds with about half the ups and downs in price.

While you're at it, opt for bond funds with low annual operating costs (or expense ratios, in fund parlance). Returns on bonds tend to be lower than those of stocks over the long-term, so high annual costs can really eat into your gains.

If you're investing money outside of tax-advantaged accounts like a 401(k) or IRA, you may also want to consider buying municipal bonds. Their yields aren't as high as the payouts on taxable bonds, but, depending on your tax bracket, those lower yields may actually turn out to be higher on an after-tax basis. (To compare taxable and tax-free yields, click here.)

You can easily screen for short- and intermediate-term funds with low costs by going to our Mutual Fund screener. Or, if you want suggestions for specific bond funds, you can check out our Money 70 list of recommended funds. I'm a particular fan of the bond index funds on the list since they offer a nice combination of broad diversification and ultra-low expenses.

I'll leave you with one last tidbit about bonds that might come in handy. If you want to know how much the value of a bond or bond fund will go up or down if interest rates rise or fall, you can find the answer in a statistic called duration.

It's too complicated to get into what it actually represents and how it's calculated, but basically it's a measure of a bond or bond fund's sensitivity to changes in interest rates. What's neat about this stat is that once you know it, you have a pretty good idea of how a bond or bond fund will fare when rates change.

So, for example, if a bond fund has an average duration of, say, five years and interest rates rise by one percentage point, the value of the bond fund will fall roughly 5 percent.

If rates rise by two percentage points, the fund will drop about 10 percent in value. The opposite occurs if rates drop. You can find the duration for a bond fund by plugging its ticker symbol into the Quotes box at the top of Morningstar's home page and after the Snapshot page comes up, click on the Portfolio tab on the left. (If you don't know the ticker symbol, go to Ticker Lookup page. If you want, you can even screen for bond funds by duration by going to Morningstar's Fund Screener.

So that's pretty much the skinny on bonds. If you stick to a well-diversified fund that sticks to the short- to intermediate-term range, has low expenses and you don't try to get fancy by timing your moves in and out of bonds based on guesses about the future direction of interest rates, you should do just fine.