Increasingly, Whether they purchase the bonds outright or invest in bond funds, more often than not we are seeing investors shifting their portfolios away from low interest-bearing accounts on short-term investments.

The basic definition of a bond is an IOU for money loaned to investors by bond issuers such as governments and corporate entities. The bond issuer will pay interest to the investor at a known coupon rate for an agreed upon period, usually until the bond matures.

Always remember, the issuer's objective is to repay the investor's principal. There are also zero-coupon bonds which are an exception that we can focus on at another time.

A bond fund is a fund invested primarily in bonds and other debt instruments. The goal of most bond funds is to generate a return for investors by investing in a variety of bonds that generate a healthy and consistent income stream.

Bond prices in general bear an inverse relationship with stock prices. Bond / bond fund investments provide balance in an investor's portfolio, each bringing different benefits, tax considerations and risks. In short, most bonds fall into these categories: corporate, government, government agencies and of course municipal bonds. The riskiest among these are corporate bonds but investors are often drawn to these bonds, especially locally issued bonds, because of the high interest rates; most even overlooking the fundamentals of the company vis-a-vis the balance sheet.

On the other hand, government bonds are generally considered to be the safest, but be aware that this is not always true as their risk is dependent on the quality of the government whose investment ratings are factored into the equation. The risks associated with government agency and municipal bonds vary, but generally fall in between corporate and government bonds on the risk spectrum.

Having a combination of different bonds and bond funds can help investors attain their objectives by assisting them to craft a portfolio appropriate to their risk profile and balancing the rest of the portfolio which may contain stocks. We know by now that there are no assurances that the objectives will be met, especially when considering all the attendant risks. However, having the appropriate mix, especially for people retiring or nearing retirement, is the fundamental issue, as clients at this stage are uncomfortable seeing large fluctuations in the value of their portfolio.

There are three main potential risks which we consider: credit risk, market risk, and interest risk.

The credit risk, as my colleague Yanique explained recently, is the risk that the bond issuer will default before the bond reaches maturity. Bonds are rated by the various credit rating agencies like Moody's and Standard & Poor's (S&P) based on the issuers' credit worthiness. Like stocks, bond prices fluctuate, and so if an investor sells or liquidates their bond prior to maturity they may make a gain or loss depending on the bond price when it was purchased versus where it is being sold at that given time.

Last but not least is the interest rate risk — when interest rates rise, bond prices will drop and vice versa. Investors in bonds and bond funds should always understand and consider these risks as they affect the prices of bonds and so can cause fluctuations in the value of an individual bond that you own or a bond fund that you are invested in.

Investors in bond funds should bear in mind that the fund managers call the shots — he or she decides which bonds to buy or sell in the fund based on the fund's objectives/ strategies.

Bond funds serve different purposes based on the various securities and hold different risks and tax benefits. Your choice must reflect and meet your needs. Although bonds and bond funds come with their own risks, you should balance the risks with the overall benefits of funds invested.

Diversification can help manage overall risk; professional management can save you the hassle of having to research and evaluate the thousands of individual bonds on the market; and lower initial investment requirements provide access to a wider variety of bonds.

The best strategy is to work with your financial manager to determine your fixed-income needs and identify your risks. This will help you to lay your fears to rest and feel confident in the bonds and bond fund you select.

Lisa Minto-Powell is the Manager, Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: [email protected]