Bonds are also the most common hedge against stock volatility, because stock market volatility will not affect bond prices. But it is a challenge for individual investors to benefit from bonds. Most bonds are offered in denominations of $1000 or higher, so an investor will need upwards of $50,000 to put together a well-diversified bond portfolio.



Enter fixed-income funds. Fixed-income funds offer small investors a way to invest smaller amounts into this essential asset class.

Investing in bonds carries two main risks: Credit Risk and Interest Rate Risk.

Credit Risk

Credit Risk is the risk that the bond's value will decline because the credit rating of the issuer falls. Many bond investors holding auto manufacturer and airline bonds have experienced this in recent years.

Government bonds are typically immune to credit risk, but emerging markets bonds are an exception. In recent years Brazil and Argentina have defaulted on obligations. Currently, Iraq bonds are at a high risk of default.

Interest Rate Risk

Bond values fall when interest rates rise. While most everybody knows this rule, few understand how and why it works.

When current yields (interest rates) rise, then new bond issues are at a higher yield than old issues. So, a bond that's six month's old will lose value if interest rates have risen, since new bonds have a higher yield.

Conversely, if interest rates are falling, a bond issued six months ago will be worth more than its original purchase price, since current issues offer a higher yield.

Mutual Funds

Interest rate risk and credit risk and bond prices in general are highly specialized areas that most individuals don't have the resources or the expertise to enter into. Furthermore, the various types of bonds issued (asset-backed, convertibles, munis, high-yield) make the bond market appear overwhelming. Fixed-income funds can offer the stable returns and expertise of experienced bond traders at a reasonable entry-level.

The best funds will allow the management to invest in a widely diversified array of bonds. Management is best able to assess the market and determine which issues are likely to perform best.

Sometimes short-term low-yield Treasury securities will be the best fixed-income investment. At other times, long-term high-grade corporate notes will be favorably priced. In the 1980s and 1990s, high-yield junk bonds, issued by companies with low credit ratings, performed best.

For this reason, diversified bond funds work best for individual investors. Such funds will benefit from all possible issuers and types. The PIMCO Total Return Fund, PIMCO Diversified Income, and the Dodge and Cox Income Fund are excellent choices with reasonable expense ratios.

Municipal bond funds offer a tax-efficient income stream, as the returns from these funds are deductible from most state and local taxes.