Now that the roaring bull that was the stock market has been put out to pasture, let us turn our attention to bonds and bond mutual funds. With investors accepting the sad reality that stock values can drop as fast as they may rise, bonds beckon as a lower-risk alternative - albeit one with a less exciting growth potential.

"Lower-risk investments like bonds have a role to play in any long-term investment portfolio because they provide diversity," said Erik Rosdahl, a private investor from Malibu, Calif. "The down side is that lower risk means lower income, but nobody wants to jeopardize all the eggs in the basket. Hedging your bets is the only way to offset overall risk."

A bond is a debt obligation not unlike an IOU. The purchaser actually lends money to the bond issuer for a fixed period at a set rate of interest, which is why bonds are known as fixed-income securities. Bear in mind that bonds are a credit risk because the issuer could default. Bonds also entail an interest-rate risk. If you purchase a bond paying 5 percent and rates rise to 7 percent, the market value of your bond has fallen compared to other bonds available at the newer, better rates.

A bond for every occasion
Bonds come in many shapes and sizes. Those issued by the U.S. government include T-bills, Treasury notes and Treasury bonds. Municipal bonds are issued by a city, county, state, school, or park district for projects such as constructing roads, bridges, schools, libraries, airports, and so on. Purchasing "muni bonds," as they are known, often comes with federal or state tax incentives. Government- or state-issued bonds tend to be lower down on the risk chain, although muni bonds can default, which is exactly what happened when Orange County, Calif., filed for bankruptcy in 1994.

Corporations issue bonds to borrow money from investors. "The risk factor with corporate bonds depends on the corporation," said Neil Corcoran, a financial planner from Skokie, Ill. "Any corporation has the potential to fail so the risk to lose some or all of your investment does exist. Bonds paying the highest interest or yield tend to have the lowest credit quality. As a rule of thumb, the lower the credit quality, the higher the yield, and the higher the yield the higher the risk."

Get your bond report cards
Mercifully, independent bond rating agencies make the shopping process less painful. Moody's Investors Service, Inc., and Standard & Poor's Corporation provide such grading systems, which essentially do your homework for you. S&P's gives investment grade ratings such as AAA, AA, A or BBB. Bonds with ratings lower than BB - B and CCC, for example - are getting into the speculative range.

"Obviously it's smart to know the credit ratings assigned to a bond before purchasing, but an investor who wants something really secure can always purchase insured bonds," said Corcoran. Major insurers of municipal bonds include groups such as Financial Security Assurance, Inc., and Municipal Bond Investors Assurance Corporation. "This way, if the issuer defaults the insurer steps in to cover the loss," added Corcoran.

Individual bonds vs. bond funds
An investor can buy into the bond market through individual bonds or fixed-income bond mutual funds. Individual bonds usually pay interest every 6 months. Bond mutual funds usually issue a monthly interest check (technically called dividends), or you can reinvest the dividends in more fund shares by way of an automatic dividend reinvestment.

Bond mutual funds can be tailored to an investor's risk tolerance. Low-risk funds include U.S. Treasury and government agency bond funds and municipal bond funds. For moderate-risk funds, one would consider investment-grade corporate bonds with a rating of BBB or better. Higher-risk funds purchase global bonds issued by governments and corporations around the world. Lastly, there are the infamous junk bond funds, which hold bonds issued by corporations with ratings of BB or lower.

"You'll get much higher yields on junk bond funds," said Corcoran, "but you're taking a far higher risk. So when financial consultants recommend you add bonds to your investment portfolio to ensure diversity, bear in mind they're not talking about junk bond funds."

- Audrey Arkins, Salary.com contributor