NEW YORK - Bond funds are getting a higher profile after years of being outshone by their more glamorous stock counterparts.
While stock prices weaken, bonds have been among the few mutual fund categories to show higher returns this year. But most experts say the decision to buy bond funds should reflect a broader financial strategy and not just a desire to outsmart the market.
"I don't think a lot of people realize how much they need to know before investing in bonds," said Daniel Roe, a financial planner in Columbus, Ohio. "The swings in bonds generally won't be as great as stocks, but you can still lose money in them."
Bonds, seen as a more conservative investment than stocks, are IOUs issued by a government or corporation to raise money. Investors who buy bonds do so on the assumption they'll get their original investment plus interest back on a certain date. The interest level is set when a bond is purchased, but the actual return may vary depending on the issuer's performance.
What's tricky about bonds is understanding how their performance - which includes the fixed interest payments plus any changes in the underlying value of the bond - correlates with the direction of interest rates in the financial markets.
Bond prices fall as interest rates rise because people might be able to find a comparable or better payoff through a different investment such as money market funds. The lower price helps make bonds more competitive.
Conversely, as interest rates fall, bonds get more pricey.
Mr. Roe, the Ohio planner, prefers bond funds to individual bonds because they spread money across the sector, instead of focusing on a few issues.
Some bond funds are actively managed, while others merely index the market. They're usually recommended for people 10 to 15 years away from retirement or for investors looking for a place to stow cash they expect to use in two to five years.
"They are also good for people who can't tolerate the volatility you normally see in stocks, although in most cases, if you have the time, you should be in stocks not bonds," Mr. Roe said.
Investors should keep four key criteria in mind when selecting bond funds, which are also called fixed income funds:
Maturity. Bond funds, like bonds, come in short, intermediate and long-term varieties depending on when they come due. Performance can also be tied to maturity. Long-term bonds and bond funds usually offer higher yields to compensate investors for tying their money up for longer periods.
Credit quality. Knowing the credit rating of the bonds in a fund can help investors identify the true risk level of their investment - in other words, whether they're likely to get their money back when the bond matures.
For example, so-called "junk bonds," the lowest-rated corporate bonds, offer higher yields that pump up a fund's performance, but not all investors may be comfortable with the higher risk they carry. Standard & Poor's and Moody's are among the best known services that rate the creditworthiness of bonds.
Diversification. As with stocks, investors need to make sure their bonds are diversified in terms of type, industry and maturity among other factors. A broad index fund may suffice or investors may want to investigate more specialized offerings.
Costs. Beware of high management fees. "Once you get over about 0.6 percent fee for management, you should start getting a little nervous," Mr. Roe said.
Tax consequences also can be an issue.
Interest on municipal bond funds tends to be exempt from federal taxes and, if the holder lives in the municipality, also may be exempt from state and local taxes. There are some tradeoffs, however.
"The yields on them are lower because the market is adjusting for the tax rate," said Bob Auwaerter, a senior fixed income manager at the Vanguard Group. "But if you're in a high-income bracket, they may be a good choice."
Ultimately, investors need to approach buying a bond fund the same way they would purchase any other mutual fund. Experts say investors need to research and to learn bond terminology, which is different from the vocabulary used to talk about stocks. Also, they should ask questions of brokers, financial advisers or fund companies.
Above all, they stress, the decision to buy bonds should be part of specific financial goals, rather than just an impulse response to the weakness in the stock market.
"It's dangerous to time the markets. People who are fleeing stocks for bond funds are potentially making a mistake," said Eric Tyson, author of Mutual Funds for Dummies.