Bonds are issued with a fixed, stated interest rate which determines the semiannual interest payment to the bond holder. Those fixed interest payments, payable until the maturity date of the bonds, are constantly valued by the market relative to alternative investments to gain the same income stream.



Since the interest payments do not change, the weight of the valuation is reflected in the market value of the bond. If interest rates in general go up, an investor can have the same income stream with a smaller investment. Thus the value of the bonds goes down. Conversely, if interest rates in general go down, an investor would have to invest more to obtain the same income stream. In that case, the value of the bonds goes up.

So a bond's price will fluctuate with the financial market interest rates. Many factors affect the market interest rate, such as the world wide demand for capital and the willingness of major governments to inflate their money supply. Probably the primary factor is the action taken by the Federal Reserve as it sets the Federal Reserve Funds Rate. If the Fed Funds interest rate goes up, bond prices will go down. It is like a playground seesaw with bonds on one end and interest rates on the other. If interest rates go up the price goes down and vice versa.

We can use this information to determine the best time to buy bonds. Will the Federal Reserve continue raising interest rates or will they decrease interest rates? As of the beginning of the fourth quarter in 2006, the consensus seems to be that the Federal Reserve is done raising rates. If the economy slows down too much, the next action would be for the Federal Reserve to reduce rates which would cause bonds to gain in value. The time to buy bonds is when interest rates have peaked.

Longer term bonds usually have a higher interest rate than shorter term bonds due to the greater uncertainty associated with a longer time frame. If this is not true, you have what is called an “inverted yield curve,” which in the past has forecasted a recession. The near term negative aspect of a recession out weighs the risk of the longer time frame.

My appraisal of the bond market at this time leads me to believe that short and intermediate term bonds are attractive.

Never, NEVER, buy tax free municipal bonds in a retirement account. That would be like throwing out the baby with the bath water. The earnings in a retirement account do not incur current taxes. So you want the highest return compatible with your risk tolerance. Only hold tax free bonds in a taxable account. For retirement accounts that are tax deferred, higher yielding taxable bonds are the best choice.

Percentage of bonds holdings in any account should be based on the age of the account holder. The closer one is to retirement, the more bonds one should hold. In retirement a typical mix is 30% equities and 70% bonds.

If the return from bonds in retirement is not sufficient to maintain a steady income then one could augment the income stream with covered calls on the equity portion of the portfolio. Covered calls can return an additional 12 to 15 percent.