How to think about bonds now

Folks who had money stashed in bonds this summer, while the stock market was doing its tumultuous thing, are pretty glad they did. And the financial services industry has made it easier than ever to buy individual bonds or baskets of bonds at rock-bottom prices.

But -- of course there is a but! -- there could be a dark side to buying bonds now. If the Fed's easing moves eventually lead to increased inflation, those bonds could turn around and bite you. If long-term rates rise in response to inflation fears instead of following short-term rates down, the value of your bonds would fall.

It's confusing, and stressful enough to make the stock market look straightforward. But hiding from bonds altogether doesn't make sense, either.

Here's how to think about bonds now.

-- It's good to have some. When you temper your stock portfolio with bonds, it keeps your bottom line from falling too far, too fast, in a market meltdown. It stabilizes your return. You may not need much, though. A traditional, cautious way of deciding this is to consider your age the percentage of your long term portfolio that should be in bonds or short term money markets; 40 percent if you're 40 years old. But that's excessively conservative. T. Rowe Price's Target Retirement Fund 2030, aimed at people who will be retiring in 23 years, has 8.75 percent of its allocation in bonds.

-- You might actually be betting against the bond market without realizing it. Americans are effectively selling bonds when they borrow money, and by this definition, most of us have sold a lot of bonds in recent years. If you've got a big home equity line, some credit card debt, a mortgage and a car loan, you might want to bulk up your bond investments just to balance all that debt.

-- Individual bonds are easier than ever to buy, and offer some advantages. Most discount brokers make buying bonds as easy as buying stocks, you can shop and click. Other online brokers, including shop4bonds.com and zionsdirect.com, claim bond specialties, and have long listings of available bonds. Investors who want to stick to ultra-safe U.S. government bonds can buy them at treasurydirect.com. The main advantage of buying individual bonds is the greater certainty they offer: You know exactly when the bonds you buy will mature, and exactly how much they'll be worth on that day. Bond mutual funds, in contrast, are always fluctuating in value because they are composed of baskets of bonds; you don't know what the value will be on the day you have to sell.

Mutual funds have their advantages too. It's good to have a diverse bond portfolio, and unless you have a lot of money to put into it, a basket of funds is the way to go. If you're buying mutual funds, it's crucial that you buy inexpensive ones: High sales fees and trading costs can negate the income of a bond portfolio. And there's some evidence that it makes sense to just buy the cheapest possible funds that follow bond indexes, according to an analysis by Morningstar Mutual Funds. The easiest way to do that is to pick up shares of a bond exchange traded fund (ETF), and the choices there are widening. Earlier this year, low-cost leader Vanguard Investments (vanguard.com) issued four bond ETFs; you can slice and dice the bond market further with ETFs from Barclays Global Investors (ishares.com).

-- Smart bond strategies can bump up returns and reduce risk. One strategy, according to Morningstar, is to stick to a basic, cheap, intermediate bond fund for the bulk of your holdings, but to diversify around the edges with international bonds, high-yield (aka junk) bond funds and other types of bonds. Another strategy, called "barbells," involves holding bonds at both ends of the maturity spectrum. The really short-term holdings will bulk up returns as rates go up; the really long-term holdings will lock in better rates.

Finally, many investors who like individual bonds build "ladders" with their investments: They buy a portfolio of longer-term bonds, but vary the maturities. A laddered portfolio might consist of five five-year bonds, with one coming due every year. That enables the investor to reap higher returns and hold on to some liquidity.