Interest-rate changes create one of the chief risks you face as an investor in bonds. The market value of the bonds you own will decline if interest rates rise.

This unalterable relationship suggests the first of several risk-reducing steps you can take as a bond investor:

Don't buy bonds when interest rates are low or rising. Put your cash in a money-market fund or in certificates of deposit maturing in three to nine months. The ideal time to buy bonds is when interest rates have stabilized at a relatively high level or when they seem about to head down.

Stick to short- and intermediate-term issues. Maturities of three to five years will reduce the potential volatility of your bond holdings. They fluctuate less in price than longer-term issues, and they don't require you to tie up your money for ten or more years in exchange for a relatively small additional yield.

Acquire bonds with different maturity dates to diversify your bond holdings. A mix of issues maturing in one, three and five years will protect you from getting hurt by interest rate movements you can't control. Mutual funds are an excellent way to achieve diversity in your bond investments.

Limit default risk

Interest-rate rises aren't the only potential enemy of bond investors. Another risk to consider is the chance that the organization that issued the bonds won't be able to pay them off. It's not realistic to expect that you could do the kind of balance-sheet analysis it takes to size up a company's ability to pay off its bonds in ten, 20 or even 30 years. Assessing the creditworthiness of companies and government agencies issuing bonds is a job for the pros, the best known of which are Standard & Poor's and Moody's. If the issuer earns one of the top four "investment grades" assigned by the companies -- AAA, AA, A or BBB from Standard & Poor's, and Aaa, Aa, A or Baa from Moody's -- the risk of default is considered slight. The box below gives a detailed breakdown of the companies' rating systems for issues considered to be worthy of the investment-grade designation. (Sometimes the ratings will be supplemented by a "+" or a "-" sign.)

Ratings below investment grade indicate that the bonds are considered either "speculative" (BB, Ba or B) or in real danger of default (various levels of C and, in the S&P ratings, a D, indicating that the issue is actually in default). You can consider any issue rated speculative or lower to be a "junk" bond, although brokers and mutual funds usually call them "high-yield" issues.

Individual junk bonds are very risky and it's best to avoid them unless you're willing to study the company's prospects closely. Alternatively, you could purchase shares in a junk bond mutual fund, which would ease the risk a bit through diversification. Even then, junk bonds should never occupy more than a sliver of your portfolio.

Check the rating of any bond you're considering purchasing. A broker can give you the rating, or you can look it up in the Moody's or S&P bond guides found in many libraries. Online sources for ratings include S&P and Bondsonline.com. Moody's has a Web site, too, although you may find it difficult to search for ratings of individual companies.

For a mutual fund, the prospectus will describe the lowest rating acceptable to the fund's managers, and the annual reports should list the bonds in the fund's portfolio, along with their ratings.

In general, the lower the rating, the higher the yield a bond must offer to compensate for the risk.

Diversify by buying bonds from several issuers. The fact that a municipal or corporate bond has a high rating is no guarantee that it is completely safe.

All of the major credit-rating agencies missed the signs of distress at Enron Corporation, failing to lower their safety ratings until just days before the giant company filed for bankruptcy protection in late 2001. The raters said they had been deceived by Enron and would have dropped their ratings much sooner if they had had the facts.

Diversify bond holdings across several different issuers, whether corporate or municipal. Bonds issued by the federal government are the only exceptions to this rule. They are as safe as you're going to get.

One way to diversify your bond investments is to buy shares in bond mutual funds.

Pay attention to the news. Enron aside, the rating agencies do a good job of tracking the issues they've rated, raising or lowering ratings when they think a change is justified. Hundreds of "fallen angels" get downgraded each year, and hundreds get upgraded. The last thing you want is to have the rating of a bond issue lowered while you're holding it in your portfolio. Even a slight downgrade can affect a bond's value. To guard against downgrading, you have to pay attention to the company's prospects after you buy the bond.

Consider other factors. Ratings aren't the final word on good bond buys. In fact, the market often recognizes problems with bond issues before the rating services can react.

Consider a bond's rating in the context of other information about bond issues you might buy:

• Compare the bond's price and yield with those of bonds with identical ratings to see which is the better buy.
  
  
• Make sure you're looking at the bonds' current credit rating. Buying on the basis of an outdated rating can be an expensive mistake.
  
  
• Make sure there's a market for the bond. This advice sounds obvious, but one thing that can cause junk bonds to lose so much of their value so fast is a situation in which there are suddenly many, many sellers and very few buyers, as when bad news hits.
  
  

WHAT THE RATINGS MEAN
S&P	Moody's	What it Means
AAA	Aaa	The highest possible rating, indicating the agencies' highest degree of confidence in the issuer's ability to pay interest and repay the principal.
AA	Aa	A very high rating, only marginally weaker than the highest.
A	A	High capacity to repay debt but slightly more vulnerability to adverse economic developments.
BBB	Baa	The lowest investment-grade rating, indicating "adequate" capacity to pay principal and interest but more vulnerability to adverse economic developments.

Riding the Yield Curve

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