What are the risks involved with investing in bonds? What can one do to minimize risk when investing in bonds?

Bonds at their best are basically boring, which is probably a virtue!

Bonds are securities representing the debt of the issuer. You're buying an IOU for which the issuer must pay the bondholder a specified rate of interest for a specific period of time and then repay the face value upon maturity.

You choose the duration of bond and also credit quality. Bonds are rated with the highest ranking, AAA or Aaa, given to issuers with the best credit and the lowest ranking, D, given to issuers who have defaulted on their loans.

The good news!

Some reasons why bonds are important choices for investors seeking income:

They offer a steady stream of income that will beat bank accounts or money market funds over the long term. Intermediate-term bonds maturing in five to seven years will hold onto the value of what you have.

They serve as protection for your portfolio against drops in the stock market. Two-to five-year Treasury bonds or two-year corporate bonds help reduce risk.

You can "ladder" a portfolio by buying bonds of different maturities, so you won't be completely hammered by any market change.

But, on the other hand ...

The downside is that bonds, once a bastion of dependability, have in recent years been ravaged by unpredictable interest rate jumps and plummets. Whenever interest rates go up, the value of existing bonds goes down.

Also, corporations and governments often will call in their older, high-interest bonds so they can finance at lower rates. You usually get five-to 10-year call protection, but, when a bond is called, you'll receive just face value or a small premium. Goodbye, high return.

There's more to be concerned about:

If you're younger or middle-aged, stocks provide more growth potential than bonds. A new retiree shouldn't put all of his money into long-term bonds with the goal of living off the income. Long-term bonds are highly volatile and probably won't keep up with inflation.

What it costs?

There are several aspects of a bond's value, making it more complex than most people realize:

There's the principal, with the bond's face value known as par. A bond selling at par is worth the same amount it will be redeemed for at maturity.

Most bonds pay interest semiannually, which is called the coupon.

The market price is what you can sell your bond for before its maturity. The current price depends on market conditions.

What's most important is the total return, a combination of the annual interest and the bond's gain or loss in market value.

Buying them!

The easiest bond transactions are for new issues, offered to the public by government bodies or corporations.

The issuer pays the broker's commission. It's a bit more pricey to buy older bonds sold on the secondary market, since there will be a dealer markup.

As with stocks, shop for the best deal! If you don't want to buy individual bonds, you can instead buy shares of a bond mutual fund, which is managed by a professional and pools money together from several investors to buy many types of bonds.

When you buy bonds with a range of maturities, a technique called laddering, you are reducing your portfolio's sensitivity to interest rate risk.

If, for example, you invested only in short-term securities, the kind least sensitive to changing interest rate risk, you would have a high degree of stability, but you might be giving up yield.

Conversely, investing only in long-term securities may result in greater returns, but their prices will be more volatile, exposing you to losses should you have to sell before maturity.

Building a laddered portfolio involves buying an assortment of bonds with maturities distributed over time. For example, you might invest equal amounts in securities maturing in two, four, six, eight and 10 years.

In two years, when the first bonds mature, you would reinvest the money in a 10-year maturity, maintaining the ladder.

Your return would be higher than if you bought only short-term issues. Your risk would be less than if you bought only long-term issues.

You would be better protected against interest rate changes than with bonds of one maturity.

If interest rates fell, you'd have to reinvest the securities maturing in two years at a lower rate, but you'd have the above-market return from the other issues.

If rates rose, your total portfolio would pay a below-market return, but you could start correcting that in two years or less when your shortest issue matured.

Barbell:

This strategy also involves investing in securities of more than one maturity to limit your risk against fluctuating prices.

But instead of dividing your money in a series of bonds distributed over time, as with a laddered portfolio, you'd concentrate your holdings in bonds with maturities at both ends of the spectrum, long -- and short-term -- for example, bills or notes maturing in six months or a year, and 20 or 30-year bonds.

Bond Swap:

Investors use bond swaps to realize a variety of benefits. A swap, the simultaneous sale of one security and the purchase of another, may be done to change maturities, upgrade the credit quality of the portfolio, increase current income or achieve a number of other objectives.

The most common swap is done to achieve tax savings. Anyone owning bonds selling below their purchase price and having capital gains or other income which could be partially, or fully, offset by a tax loss can benefit from a tax swap.

In a two-step process, the investor would sell a bond that is worth less than what he paid for it and would simultaneously purchase a similar bond at approximately the same price.

By swapping the securities, the investor has converted the paper loss to an actual loss which can be used to offset capital gains of ordinary income each year on a joint return.