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Bond Investing – An Introduction

Although financial headlines tend to gravitate toward the latest gyrations of glamorous stocks, fixed-income investments such as bonds might make for a smart complement in your portfolio.

Unlike a stock, which represents ownership in a company, a bond is more like a loan or an IOU. You lend money to a company or government entity in exchange for regular interest payments, plus return of the full loan amount, or face value, when the loan matures.

While the underlying mechanics of bonds are relatively simple, you should be aware that a wide range of variables can add complexity to buying bonds. Yet understanding bonds isn't as daunting as it might appear and can be rewarding-personally and financially.

Individual characteristics of bonds are important to know when buying bond mutual funds, which, like stock funds, consist of a large number of holdings. Bond funds typically fall into certain categories and buy and sell bonds continuously, unlike a single bond held to maturity.

So why include bonds in your investment mix? One key reason is that they can decrease volatility to your portfolio during the inevitable stock market fluctuations. "They can temper overall risk and volatility, and by owning a certain portion of fixed-income securities, you can diversify your asset base," says Jay Mueller, fixed-income portfolio manager at Wells Fargo Advantage Funds®.

Bonds are generally considered less volatile than stocks, but there are many factors that can affect the relative risk of any investment. Bonds are also attractive if, in addition to hopeful long-term profits from stocks in your portfolio, you also want a regular stream of current income.

Because individual bonds can be expensive and complicated to select, an attractive alternative is a bond mutual fund.

Diversification

A bond fund usually holds hundreds of individual bonds in its portfolio, thereby minimizing the damage from a single default. In contrast, an individual investor may be able to afford only a few bonds, thereby incurring increased exposure to unforeseen events.

Professional Management

With thousands of bonds to choose from, you would need a great deal of expertise and time to make prudent decisions. Professional managers have the experience and resources to ferret out bonds that match the investment objectives of the fund.

Current Income

Bond funds generally make interest payments monthly, compared to individual bonds, which normally pay interest every six months. You also have the option of reinvesting interest payments rather than receiving them as cash.

Liquidity

It's easy to buy and sell shares of a bond fund when the need arises. You don't have to wait for individual bonds to mature to take money out of your account.

Affordability

Individual bonds can cost as much as $10,000 each – too expensive for many investors. Yet bond funds typically require a smaller initial investment to get you started, greatly lowering the barrier to bond ownership.

Tax Benefits

Depending on your tax bracket and other factors, investing in bond funds with interest exempt from federal taxes can be an appealing alternative to taxable bonds.

As you can see, bond mutual funds have a number of advantages. Yet, it can't be overemphasized that there are a number of important considerations when investing in bonds or bond funds. Subsequent articles in this series on bond investing will help you gain a deeper understanding of how to tailor bond funds to your particular circumstances.

Stock funds should only be considered for long-term goals as values fluctuate in response to the activities of individual companies and general market and economic conditions. Bond fund values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. In general, when interest rates rise, bond fund values fall and investors may lose principal value. Some funds, including non-diversified funds and funds investing in international securities, high yield bonds, small- and mid-cap stocks and/or more volatile segments of the economy, entail additional risk and may not be appropriate for all investors. Consult a Fund's prospectus for additional information on these and other risks.

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