Since the early 1980s, interest rates have been on a secular decline. Since the credit crisis, governments across the world have worked to flood global financial markets with liquidity, which includes low interest rates, to try and stoke economic growth. This has served to push most interest rates to all-time lows, be it those paid on government securities, mortgage rates or the rates that banks borrow from and lend to each other. (For related reading, see Forces Behind Interest Rates.)

See: Bond Basics

With interest rates across the board so low, there is a pretty wide consensus that they will trend up in 2012 and beyond. Because bond prices move in the opposite direction of interest rates, investors holding bonds have a good chance of losing money on their holdings over the next few years. However, as with any asset class, there are pockets of the market where investors should be able to protect their principal and earn reasonable rates of returns in their bond portfolios. Below are four ways that bonds can fit into your investment profile during 2012.

Municipal Bonds
About a year ago, market strategist Meredith Whitney boldly predicted that municipal bonds in the United States would eventually see hundreds of billions of dollars in defaults, as local municipalities struggle with lower tax revenue due to the credit crisis and also find it difficult to operate after years of generous retirement benefit promises and related operating costs. Other strategists echoed her negative sentiment, which served to send many investors fleeing from municipal bond funds and individual bond positions.

Lower demand has served to push bond prices down and rates up. The rate on an AAA-rated five-year municipal bond is currently at roughly 0.79%, which is currently below the current Treasury bond yield of about 0.86% for the same maturity. Additionally, municipal bonds are generally exempt from federal taxes as well as most state and local tax rates. As a result, the tax equivalent yield is even higher, and moving into lower-rated bonds that are still investment grade could garner higher rates. A five-year A-rated municipal bond yields approximately 1.35%. (To learn more, read Avoid Tricky Tax Issues On Municipal Bonds.)

Corporate Bonds
AAA corporate bonds with a five-year maturity currently yields around 1.8%, which compared to the yield of municipal bonds with the same rating is more than double. A 20-year AAA corporate bond rate is somewhat decent at around 4.45%, though it requires locking up your money in a security that doesn't reach maturity until two decades later. As with the municipal bonds, sacrificing quality but still sticking in the investment grade category can allow for some pick up in yield. For instance, those brave enough to invest in bonds issued by banks and other financial institutions, can find yield to maturities of as much as 9%.

High-Yield Bonds
Sticking on the braver side of the bond market, high-yield bonds - which is a euphemism for junk bonds - offer plenty of opportunity to gamble for yields that can match the returns of stocks. A current perusal of some high-yield bonds, which are of a much lower credit rating than the investment grade bonds mentioned above, offer yield to maturities into the double digits. Clearly, the bonds with yields in the teens on up carry significant default risk, meaning investors can lose all of their money if the firm falls into further financial distress or ends up declaring bankruptcy. (Also, check out Junk Bonds: Everything You Need To Know.)

Convertible Bonds
Convertible bonds are an interesting subset of the bond market in that they combine features of traditional bonds with stocks. Like a bond, convertibles usually have a maturity date and pay a regular coupon, which should appeal to income-minded investors. They also tend to trade like a bond in a weak market environment or when company fundamentals are weak. But they also have the upside of a stock as they are convertible into the underlying company's stock. As such, they can trade much like a stock as it reflects the performance of the stock they are convertible into. Coupon rates vary and are generally quite low, but, again, offer more upside if the underlying stock performs well.

The Bottom Line
The bond market generally does not favor investors these days. The fact that companies, governments and municipalities are jumping at the chance to issue debt at low interest rates speaks to the fact that rates are at historic lows. Recently, a 10-year Treasury bond was issued with a coupon rate below 2%, which is the first time rates were ever this low. Despite the challenging overall outlook for the asset class, there are plenty of opportunities to find ways for bonds to fit into your portfolio. (For more information, read the Top 6 Uses For Bonds.)

Related Articles
  1. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  2. Investing

    How ETFs May Save You Thousands

    Being vigilant about the amount you pay and what you get for is important, but adding ETFs into the investment mix fits well with a value-seeking nature.
  3. Mutual Funds & ETFs

    Mutual Funds Millennials Should Avoid

    Find out what kinds of mutual funds are unsuitable for millennial investors, especially when included in millennial retirement accounts.
  4. Bonds & Fixed Income

    High Yield Bond Investing 101

    Taking on high-yield bond investments requires a thorough investigation. Here are looking the fundamentals.
  5. Retirement

    How Robo-Advisors Can Help You and Your Portfolio

    Robo-advisors can add a layer of affordable help and insight to most people's portfolio management efforts, especially as the market continues to mature.
  6. Investing Basics

    Investing $100 a Month in Stocks for 30 Years

    Find out how you could potentially earn hundreds of thousands of dollars by just investing $100 a month in stocks during your working years.
  7. Mutual Funds & ETFs

    Top 3 Muni California Mutual Funds

    Discover analyses of the top three California municipal bond mutual funds, and learn about their characteristics, historical performance and suitability.
  8. Mutual Funds & ETFs

    Top 3 Japanese Bond ETFs

    Learn about the top three exchange-traded funds (ETFs) that invest in sovereign and corporate bonds issued by developed countries, including Japan.
  9. Taxes

    Here's How to Deduct Your Stock Losses From Your Tax Bill

    Learn the proper procedure for deducting stock investing losses, and get some tips on how to strategically take losses to lower your income tax bill.
  10. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  1. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
  2. Do mutual funds pay dividends?

    Depending on the specific assets in its portfolio, a mutual fund may generate income for shareholders in the form of capital ... Read Full Answer >>
  3. What licenses does a hedge fund manager need to have?

    A hedge fund manager does not necessarily need any specific license to operate a fund, but depending on the type of investments ... Read Full Answer >>
  4. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
  5. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  6. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  2. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  3. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  4. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  5. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  6. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!