5 Things You Really Need to Know About Bonds Right Now

United States Savings Bonds
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Most investors believe that the stock market is the riskiest way to invest. But as many investors have learned the hard way lately, even supposedly safe investments like bonds can create losses in your portfolio.

For years, the Federal Reserve has done everything it could to keep interest rates low. But now that the Fed has started thinking about plans to cut back on some of the methods it has used to reduce rates, the bond market has suffered big declines, with losses of 10 percent or more for some types of bonds.

Here are five things you need to understand about bonds in order to make sure rising rates don't cause you any further nasty surprises.

1. Rising Interest Rates Hurt Bond Prices

Many bond investors make the mistake of thinking that rising yields on bonds are a good thing. That's true for new investors, as newly issued bonds will carry higher interest rates than older bonds.

But if you already own bonds, rising yields cause your bonds' value to fall. That's because as new bonds with higher rates come out, your lower-rate bond looks less attractive by comparison, and so buyers aren't willing to pay as much for your bonds, causing their prices to drop.

2. Longer-Term Bonds Move More When Rates Change

Typically, investors can get higher rates by buying long-term bonds. For instance, 30-year Treasury bonds pay almost 4 percent right now, compared to about 0.5 percent for two-year Treasuries.

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The tradeoff, though, is that yield increases hurt the value of long-term bonds a lot more than short-term bonds. The reason: The longer you're locked into a relatively low rate, the more interest you lose from being stuck with that bond.

By contrast, even if rates rise substantially on a bond that matures within a few months, you won't lose much value because you'll soon be able to take your money at maturity and reinvest it in a higher-rate bond. That's one reason why so many analysts have advised bond investors to focus on shorter-term bonds lately.

3. Individual Bonds Have One Big Edge Over Bond Funds

Most investors buy bond funds for diversification rather than individual bonds. With bond funds, you can get exposure to dozens or even hundreds of different bonds even if you only have a modest amount to invest. To buy that many individual bonds, it would cost you tens or even hundreds of thousands of dollars.

However, one attractive feature of individual bonds is that even if their market value declines due to interest-rate rises, individual bonds eventually recover to their full par value at maturity. For bond funds, on the other hand, capital losses can be permanent because most bond-fund managers typically buy and sell bonds rather than holding them to maturity.

4. Municipal Bonds: Attractive Yields with Tax Benefits

Within the bond market, different niches have had varying results. Municipal bonds have seen an especially large run-up in yields, and right now, 30-year municipal bonds have yields that are almost a full percentage point above comparable Treasury yields.

What's particularly unusual about the current muni-bond environment is that munis usually have lower yields than Treasuries. That's because muni interest is exempt from federal tax, providing even greater after-tax returns than taxable Treasuries and other bonds. The recent Detroit bankruptcy has highlighted the risks of muni-bond investing, but high yields make that risk worth it for many investors, especially if you're in a high tax bracket.

5. Inflation-Protected Bonds Can Still Lose Value

Most bonds are vulnerable to inflation. That's one reason why inflation-protected bonds like Treasury Inflation-Protected Securities, aka TIPS, have become popular.

Yet the rise in bond yields lately hasn't come from inflation fears but rather from the Fed's anticipated policy changes. As a result, TIPS yields have also risen, causing big price declines in them as well.

Be Careful With Bonds

Having bonds in your portfolio still makes sense for most investors who can't afford to take on the full risk of the stock market and other riskier assets with their entire portfolio. By keeping these five things in mind, you can do your best to minimize any losses and take advantage of opportunities as they arise.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google+.

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5 Things You Really Need to Know About Bonds Right Now

Primarily covering the energy and natural resources sectors, master limited partnerships take advantage of favorable tax laws to distribute cash to investors in a tax-efficient way.

Recently, the need for pipelines and other energy infrastructure to transport huge, newly-discovered oil and natural gas reserves has helped MLPs like Kinder Morgan Energy Partners (KMP) and Enterprise Products Partners (EPD) to grow substantially while paying distribution yields of between 4 percent and 6 percent. Many MLPs pay even higher yields, however, and with those payouts often being tax-advantaged, you'll potentially lose less of your income to Uncle Sam.

The downside: MLPs can make your tax preparation a lot harder, as complicated reporting requirements make them harder to deal with than an ordinary stock investment.

Another tax-law provision gives favorable tax status to real-estate investment trusts. REITs make investments in real estate-related assets, and they're required to pay out almost all their income to their shareholders annually.

Simon Property Group (SPG) is one of the biggest REITs, focusing on shopping malls and paying a 3 percent yield. But other specialty areas of the REIT universe pay much higher dividends, with REITs like Annaly Capital (NLY) that invest in mortgage-backed securities topping the list with double-digit percentage yields.

Beware, though: Many mortgage REIT dividends fallen recently as the Federal Reserve has invested heavily in mortgage-backed securities.

If you like the idea of profiting from helping small businesses grow, then business development companies may look attractive to you. BDCs provide financing to growing small private businesses, typically through loans that may also include the right to take an ownership position in a company.

With extensive portfolios, BDCs are typically well-diversified, and many of them, including Prospect Capital (PSEC) and Apollo Investment (AINV), pay yields approaching 10 percent. Some BDCs, however, don't pay any dividends at all, so be sure you look closely before you commit your capital to a BDC.

These precursors to exchange-traded funds have been around for decades. Closed-end funds own diversified portfolios of investments, and some, such as PIMCO High Income (PHK), use a combination of high-yield junk bonds, leverage, and managed payouts to maintain distribution yields well above 10 percent.

What to watch out for: Sometimes, the income that closed-ends pay is actually a return of investors' capital. Moreover, closed-end shares can trade at big premiums to the value of their underlying assets, causing high-risk situations in which your investment can lose value even if the underlying portfolio owned by the fund goes up.

Trust deeds involve direct investment in loans secured by real estate. Unlike mortgage-backed securities, which represent bundles of loans involving thousands of different mortgages that have been packaged and repackaged, trust deeds are directly tied to individual properties.

Because of the difficulty that many homeowners have had in recent years getting traditional mortgages, trust deeds offer attractive yields, with some in the high single-digit to low double-digit return range. You can also buy pools of trust deeds that give you partial interests in a larger number of different properties.

The downside: If a borrower stops repaying the loan backed by the trust deed, you may be forced to take action such as foreclosing to preserve your investment, and if real-estate prices have fallen, your entire investment can be at risk.

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