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Short-term or long-term? Bonds and interest rates teeter on opposite ends of a seesaw: If interest rates rise, bond prices fall—although a short-term bond falls far less than a long-term bond. On the other hand, if interest rates fall, bond prices rise—and a long-term bond will outper-forms shorter ones.8 You can split the difference simply by buying intermediate-term bonds maturing in five to 10 years—which do not soar when their side of the seesaw rises, but do not slam into the ground either. For most investors, intermediate bonds are the simplest choice, since they enable you to get out of the game of guessing what interest rates will do.

Bonds or bond funds? Since bonds are generally sold in $10,000 lots and you need a bare minimum of 10 bonds to diversify away the risk that any one of them might go bust, buying individual bonds makes no sense unless you have at least $100,000 to invest. (The only exception is bonds issued by the U.S. Treasury, since they’re protected against default by the full force of the American government.)

Bond funds offer cheap and easy diversification, along with the convenience of monthly income, which you can reinvest right back into the fund at current rates without paying a commission. For most investors, bond funds beat individual bonds hands down (the main exceptions are Treasury securities and some municipal bonds). Major firms like Vanguard, Fidelity, Schwab, and T. Rowe Price offer a broad menu of bond funds at low cost.9

The choices for bond investors have proliferated like rabbits, so let’s update Graham’s list of what’s available. As of 2003, interest rates have fallen so low that investors are starved for yield, but there are ways of amplifying your interest income without taking on excessive risk.10 Figure 4-1 summarizes the pros and cons.

Now let’s look at a few types of bond investments that can fill special needs.

Cash is not Trash

How can you wring more income out of your cash? The intelligent investor should consider moving out of bank certificates of deposit or money-market accounts—which have offered meager returns lately—into some of these cash alternatives:

Treasury securities, as obligations of the U.S. government, carry virtually no credit risk—since, instead of defaulting on his debts, Uncle Sam can just jack up taxes or print more money at will. Treasury bills mature in four, 13, or 26 weeks. Because of their very short maturities, T-bills barely get dented when rising interest rates knock down the prices of other income investments; longer-term Treasury debt, however, suffers severely when interest rates rise. The interest income on Treasury securities is generally free from state (but not Federal) income tax. And, with $3.7 trillion in public hands, the market for Treasury debt is immense, so you can readily find a buyer if you need your money back before maturity. You can buy Treasury bills, short-term notes, and long-term bonds directly from the government, with no brokerage fees, at www.publicdebt.treas.gov. (For more on inflation-protected TIPS, see the commentary on Chapter 2.)

FIGURE 4-1 The Wide World of Bonds

Sources: Bankrate.com, Bloomberg, Lehman Brothers, Merrill Lynch, Morningstar, www.savingsbonds.gov

Notes: (D): purchased directly. (F): purchased through a mutual fund. “Ease of sale before maturity” indicates how readily you can sell at a fair price before maturity date; mutual funds typically offer better ease of sale than individual bonds. Money-market funds are Federally insured up to $100,000 if purchased at an FDIC-member bank, but otherwise carry only an implicit pledge not to lose value. Federal income tax on savings bonds is deferred until redemption or maturity. Municipal bonds are generally exempt from state income tax only in the state where they were issued.

Savings bonds, unlike Treasuries, are not marketable; you cannot sell them to another investor, and you’ll forfeit three months of interest if you redeem them in less than five years. Thus they are suitable mainly as “set-aside money” to meet a future