These Investments Pay You Big Bucks

In the interest of full disclosure, there are two things you should know right up front:

1. This article is about bonds.
2. You should read it anyway.

I know what you're thinking -- bonds are boring! They're stodgy, dusty old things best left to other people, not worthy of real investors' attention until retirement age -- and maybe not even then.

But diversifying your holdings by adding some bonds can have powerful effects. Properly done, you can end up trouncing an all-stock portfolio -- while lowering your overall volatility.

Have I got your attention yet?

If the possibility of more market volatility is keeping you up at night (and if you're close to retirement, or in retirement, it should be), bonds deserve your full attention.

The basics of bonds
As with the best dividend stocks, a corporate bond can be a great source of income. Unlike stocks, though, bond values are less likely to track the stock market's volatility -- in fact, they often rise when stocks are falling, which is one reason asset allocation works so well. And if things go really bad, your chances of getting at least some of your money back are far higher with bonds than with stocks.

Bond types and details vary, but the basics are pretty simple:

• A bond is an IOU -- a promise to pay back a certain sum on a certain date (the bond's maturity date), with a particular rate of interest (the bond's coupon) paid over time.
• Bonds trade in a secondary market, and their prices fluctuate, which means the actual rate of interest you'll realize -- the bond's yield -- depends on what you paid for the bond. But bond prices tend to be more stable than stocks over time. They are most sensitive to two things: interest rates, since the bond's yield has to compete with the rates you can get elsewhere; and the issuer's creditworthiness, because bondholders like to actually be paid back, and they generally want a higher yield to compensate for higher levels of risk.
• Bonds are also sensitive to inflation, but some bonds have inflation-protection features built in.

Buying bonds is not the same as buying stocks, but it's not complicated.

How to buy a bond
Foolish retirement guru Robert Brokamp recently took a look at bond investing, and came to an interesting conclusion: While you can invest in bonds via a bond mutual fund -- and many folks do -- there are some interesting advantages to buying bonds directly. The biggest one is pretty simple: You'll know exactly what you own and what it's worth. If volatility is truly a major concern, taking the opacity of a bond fund out of the equation can be a big deal.

Robert's article, which appears in the new issue of the Fool's Rule Your Retirement newsletter, goes into great detail on the nuts and bolts of bonds and bond-buying, so I won't rehash it here. But that said, there are some key things to know.

For instance, corporate bonds aren't traded on an exchange like stocks. Your broker will have an inventory of bonds to choose from, and some way to search through it online to find bonds with the characteristics you want.

I spent a few minutes hunting through Fidelity's bond inventory to turn up some examples, shown in the chart below. Your broker may not have the same offerings available when you go to buy -- but these are examples of the kinds of things you're likely to find.

Source: Fidelity Investments. Yield to maturity based on ask price as of morning of Nov. 5.

So what's interesting here? First, looking at Fidelity's screens, the investment-grade corporate bonds with the highest yields to maturity -- by far -- were AIG offerings. Clearly, investors don't believe that those bonds are really investment-grade, despite the company's A- rating from Standard & Poor's. The market has shied away from these bonds, driving secondary-market prices down and yields up.

In fact, note how the AIG bond compares to the deep-junk-rated (anything below BBB is considered below "investment-grade" -- "junk" or "high income" in Wall Street parlance) Ford issue, which is trading at a lower yield. There may be other factors at work, but one could come away with the conclusion that the market thinks Ford is a better credit bet at this particular moment than AIG.

Interesting, no?

See, bonds aren't as boring as you thought. If you'd like to learn more about how to buy and hold a portfolio of bonds, I encourage you to check out Robert's article, available online at 4 p.m. ET today. Not a Rule Your Retirement member? No worries -- a free trial gets you full access for 30 days, with no hassles. Just click here to get started.