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Bond values go down when interest rates go up Holding a bond to maturity does not protect you from interest rate risk Bond fund can protect the portfolio by shifting investments when interest rates change

Money Watch, a personal finance column that runs every Saturday, features a financial planner from the National Association of Personal Financial Advisors answering reader questions about saving, protecting and growing your money. To submit a question, e-mail USA TODAY personal finance reporter Christine Dugas at: cdugas@usatoday.com.

Q: If interest rates are close to zero are bonds still a good investment?

A: Bonds in limited circumstances can still be a good investment.

Before you make any decisions, it’s a good idea to review the basics of bond funds. Bond values move in the opposite direction of interest rates, so the value of a bond will drop when rates go up, and vice versa.

It’s important to know a bond fund’s duration and credit quality, because that information will tell you how risky the fund is, and if it’s right for your situation. For example, if a fund’s average duration, a measure of interest-rate sensitivity, recently stood at six years, that suggests that the fund’s shares would lose about 6% if interest rates rose 1 percentage point.

If you buy individual bonds and hold them to maturity, you will not lose principal because interest rates rose. But inflation can take a major bite out of your portfolio returns over time. That’s because there is a difference between the nominal return, which is the return that a bond provides on paper, and the real or inflation-adjusted return. If you invest $100 in a short-term bond with a 1% yield, your investment rises to $101 over the course of the year. But in real money, you may have lost purchasing power because inflation is running at about 1.50% a year.

Bond funds tend not to hold their bonds to maturity and as a result they will lose principal when interest rates rise. However, bond funds may attempt to protect their portfolio by shifting to shorter durations and cash when rates start to rise. If rates have peaked, they could end up buying long-term bonds at discounted prices.

Interest rates have been low for more than three years. During that time, investment-grade bonds have returned nearly 20% since then, vs. 0.20% for money-market funds. But no one knows how far they’ll rise and when that will happen.

My recommendation is to use low-cost bond mutual funds with durations of roughly two to four years and whose managers say they are worried about the sudden return of inflation damaging the bond market.

Recently, many retail bond investors have shortened the term of their bond holdings to intermediate term or short term so as to reduce the risk of being hurt by a sudden upward movement in interest rates.

Bond investors tend to be cautious older people who remember the great inflation of the 1970s and the 1994 mortgage bond crash, so they are definitely positioning themselves to protect from a bond market blowup. Thus, it is unlikely there will be a mass panic out of bonds.

Even though bond prices are very high, there are reasons why these prices are legitimate. There have been periods in U.S. and Japanese history where interest rates stayed very low for more than 20 years. We have only had low rates for about seven of the last 10 years. However, long-term bonds are still risky, in case inflation was to return along with higher interest rates.

I view bonds as a parking lot for assets, like paying for parking to protect a car, while waiting for the right opportunity to buy stocks after a stock crash.

What I mean by saying paying for parking is that today’s bond yields are so low that it feels like the low rate has an opportunity cost compared to what people were used to getting a decade ago from bond yields. I would rather endure the pain of this opportunity cost than risk losing money in what I feel is an overpriced stock market.

Mayflower Capital, Los Altos, Calif.