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. Investing Basics

    Contingent Convertible Bonds: Bumpy Ride Ahead

    European banks' CoCos are in crisis. What investors who hold these high-reward but high-risk bonds should know.
  2. Mutual Funds & ETFs

    The 3 Best T. Rowe Price Funds for Value Investors in 2016

    Read analyses of the top three T. Rowe Price value funds open to new investors, and learn about their investment objectives and historical performances.
  3. Active Trading Fundamentals

    4 Stocks With Bullish Head and Shoulders Patterns for 2016 (PG, ETR)

    Discover analyses of the top four stocks with bullish head and shoulders patterns forming in 2016, and learn the prices at which they should be considered.
  4. Investing

    3 Healthy Financial Habits for 2016

    ”Winning” investors don't just set it and forget it. They consistently take steps to adapt their investment plan in the face of changing markets.
  5. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  6. Fundamental Analysis

    3 Reasons To Not Sell After a Market Downturn

    Find out the reasons that it is not a good idea to sell after a market downturn. There are lessons to be learned from the last major market downturn.
  7. Fundamental Analysis

    HF Performance Report: Did Hedge Funds Earn Their Fee in 2015?

    Find out whether hedge funds, which have come under tremendous pressure to improve their performance, managed to earn their fee in 2015.
  8. Sectors

    2016's Most Promising Asset Classes

    Find out which asset classes are considered to be the most promising for generating portfolio returns and reducing volatility in 2016.
  9. Mutual Funds & ETFs

    3 Morgan Stanley Funds Rated 5 Stars by Morningstar

    Discover the three best mutual funds administered and managed by Morgan Stanley that received five-star overall ratings from Morningstar.
  10. Retirement

    Smart Ways to Tap Your Retirement Portfolio

    A rundown of strategies, from what to liquidate first to how much to withdraw, along with their tax consquences.
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  3. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
  4. Are UTMA accounts escheatable?

    Like most financial assets held by institutions such as banks and investment firms, UTMA accounts can be escheated by state ... Read Full Answer >>
  5. What are the dormancy and escheatment rules for stock accounts?

    While the specific dormancy and escheatment rules for stock accounts vary by state, all states provide for the escheatment ... Read Full Answer >>
  6. What are the maximum Social Security disability benefits?

    The average Social Security disability benefit amount for a recipient of Social Security Disability Insurance (SSDI) in 2 ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center