Bonds certainly do not seem as sexy or fun as stocks. Typically when people talk about investing they automatically gravitate towards the stock market or whatever is the hot, flavor of the day such as real estate. Bonds are also usually associated with investment vehicles designed for retirees who need income. Income generation aside, bonds really have a place in nearly everyone's portfolio. Simply put, if stocks offer the best hedge against inflation (increase of goods and services over time), then bonds tend to be one of the best hedges we have against stock market volatility. Why? Because bonds are lower risk investments, behave differently than stocks, and have a low correlation to stocks meaning that if the stock market is doing badly bonds are probably holding there own and vice versa.

Most people own bonds to some degree. If not, I would seriously revisit your asset allocation. Still though, there seems to be some confusion about what type of bonds to use. Naturally, concerns and questions about diversification, risk, and strategy are common place. Many investors have questioned or favored individual bonds over bond funds for the comfort of knowing they will receive principle back at maturity. Others think that dollar cost averaging into bond funds is a good strategy - especially in a rising interest rate environment where the value of bonds go down. And lastly, many investors questioned being in long-term bonds or bond funds when interest rates hover around historic lows.

Bond Funds Versus Individual Bonds

Looking at the different characteristics of bond funds and individual bonds can help dispel some of the common misconceptions. Investors often focus on what they think it the biggest advantage of owning individual bonds: receiving their par (or original investment) back. However, investors really need to remember the negative affects of inflation (today's $1,000 returned later is worth less) and that bonds total return is a combination of appreciation/depreciation and dividends/income. Unlike stocks, 98-99% of a fixed instruments total long-term return is derived from the income portion of the equation.

Individual Bonds Characteristics

• The income portion (coupon) is fixed and received on a semi-annual basis
• Reinvested is limited to money market until enough capital is raised to purchase a new bond
• Most individual bond holders spend or fail to actually reinvest the income

Bond Mutual Fund Characteristics

• The income portion (coupons/dividends) are paid monthly
• Option for immediate reinvestment of dividends into the bond fund (in effect, continual dollar cost averaging)

In a rising interest rate environment, these two characteristics have the effect of tempering market turmoil and immediate benefiting the investor by:

• Averaging into the fund at lower share price (remember if interest rates go up, bond values go down)
• Progressively increasing the average yield of the portfolio.

Investors also tend to worry about the value of bonds in a rising interest environment. The confusion typically stems from the fact that. The Net Asset Value (NAV) of a bond fund is priced daily and, in a rising interest rate environment, causes investors to to have an unrealized loss of NAV. This would an identical situation if investors priced their individual bonds on a daily or regular basis. However, individual bond pricing is transparent and normally unavailable for the most part to the ordinary investor. By not pricing their individual bond securities, the investor does not "feel" or assume that they have a negative total return for the reporting period. They only tend to "feel" or assume that they have received their coupon payment and will receive their par value at maturity. This flawed analysis when comparing individual bonds to bond funds leads to the temptation of never using bond funds.

Why Not Dollar Cost Average (DCA) into Bond Funds?

• Very few bond markets produce negative total returns. The most recent in 1994 and 1999 were losses of -2.92% and -.82% respectively
• The objective of a DCA strategy used in equity or stock allocations is to reduce the risk of investors liquidating their entire positions after a sharp decline.
• Over the long-run, the price component (capital gain/loss) has little impact on the total return of fixed income (bonds) securities.
• Bonds are a key component of an investors portfolio. They are used to mitigate the volatility of the equity side of a portfolio and act as a hedge. Using a DCA strategy to add a hedging component of an investor's portfolios increases the overall risk of the portfolio.

Why Long-Term Bonds?

• Longer maturity bonds offer higher average yields. The higher dividend flows result in higher reinvestment returns (again, the major component of fixed income total returns)
• Long-term bonds are only one component of an overall fixed income strategy. Most investors should have a mixture of short-term, intermediate-term, and long-term bonds with the objective of participating in the historically higher returns of long-term bonds while tempering the greater volatility inherent in this sector through heavier allocations to shorter-term and intermediate-term bonds. The average duration should still fall in the intermediate-term spectrum.
• no one can truly predict interest rates. 1998, for instance, brought the extraordinary global events that sent Treasury Yields to all time lows in an unforeseen global flight to quality. By February of 1999, investors thought the worst was over, but yields climbed another 200 basis points. Timing these events is difficult and best left to fund managers.

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