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The Pros and Cons of Bonds

Bonds are steady, not sexy.

Investment advisors are fond of saying that bonds are the ballast for your portfolio. Stocks go up and down, but bonds -- government or corporate debt that is repaid on a set schedule -- are designed to deliver income with metronomic regularity.

Bonds have been uncharacteristically controversial after the financial crisis. That's because they are usually worth more when interest rates drop. But rates have been artificially low due to the monetary policies of the Federal Reserve. That means the usual yardsticks of bond performance and value are less relevant -- at the moment.

There are plenty of factors to sort through as you consider how to use bonds to achieve your investment goals.

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[See: 7 Things Your Financial Advisor Should Not Tell You.]

But the first and most important question, says Russ Koesterich, BlackRock's chief investment strategist, is not really about bonds. It's about your need for steady income.

A balanced portfolio usually has some growth holdings (like stocks, which hopefully will gain value) and some income holdings (like bonds, which regularly deliver income). Preretirees, who are accumulating assets, are less likely to need a high percentage of bonds because their goal is usually to reap returns from investing. But upon retirement, investors start depending on their portfolio income -- and that's when the reliable income from bonds becomes essential.

"If income is your goal, you'll own more bonds than the person who's focused on total return," Koesterich says.

Once you understand your income needs, dig into the specifics of bonds.

[Read: A Guide to Financial Advisor Fee Structures.]

Decisions include:

-- Individual bonds or bond mutual funds? Individual bonds are very expensive, and it takes a lot of them to diversify a portfolio, advisors warn. Funds, even though they charge a fee, allow investors to gain the solidity and income stream from a portfolio without putting all their chips on a single bond. "Unless you have several hundred thousand dollars to put into your own custom basket of bonds, buy into a bond fund," says Erik Davidson, deputy chief investment officer for Wells Fargo Bank. "A bond fund gives you one-click diversification."

-- Buy and hold or buy and expect to sell? Funds offer a variety of maturities and a way to exit the investment, which is why advisors often recommend them. Individual bonds or funds with strict requirements to hold are often too constraining for most investors.

-- High-yield bonds or municipal bonds? As with all investments, greater risk comes with greater rewards. If you're buying bonds as an anchor, you have to weigh the wisdom of choosing a risky anchor, even if that anchor is steady compared with the growth portions of your portfolio. Municipal bonds, which come with tax advantages, are tempting but "only make sense if you're in a higher tax bracket and your taxes are increasing," Davidson says. Also, do you have the time, patience and insight to monitor the creditworthiness of exotic bonds or bond substitutes?

"The purpose of bonds in a portfolio is to act as a shock absorber," says Allan S. Roth, certified financial planner and founder of Wealth Logic LLC, based in Colorado Springs, Colo. "Stocks are riskier in a day than high-quality bonds are in a year."

Because bonds form the bedrock of a portfolio, he typically advises clients to invest in the highest quality bonds they can. As your overall portfolio grows in value, you will likely want to convert some gains into bonds, especially as you approach retirement, Roth says.

[Read: How to Budget For Health Care Expenses in Retirement.]

It's hard to abide by that classic wisdom, though, when bonds seem to be a lose-lose proposition. Once Federal Reserve policy changes and interest rates start to rise, bonds are sure to lose value. "There's no point in buying something that will go down," says William Jerome, a certified financial planner based in Glenville, N.Y.

He recommends safe, income-producing investments that can be reasonable alternative to bonds, such as publicly traded partnerships, including real estate investment trusts and business development corporations, which, he says, typically yield 8 percent to 10 percent.

Davidson says another alternative is laddered bond funds, which can provide an escape hatch if interest rates start to climb. Laddered bond funds with successive maturities can help boost your bond income. But volatile interest rates mean investors must closely monitor the asset balance in their portfolios and how quickly they can respond to shifting conditions. "If rates go up and if inflation is unleashed, you don't want to have too much in bonds," Davidson says.

Different types of bonds, such as international bonds, might fit the bill , Koesterich says. The key, he says, is to strike the right balance between reliable income and protecting that income from inflation. "If you're an investor looking for income, you'll have to cast a wider net," he says. Even with bonds, there's no such thing as automatic pilot.



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