RachelKoning Beals

CHICAGO (MarketWatch) — Bonds are typically seen as a lower-risk accessory to a stock portfolio, a cardigan sweater tossed over a party dress.

A collection of United States debt certificates.

Yet bonds leave many investors scratching their heads: How much of an investment plan should be allocated to fixed income? Are bonds only for those nearing or in retirement? How can performance be tracked? Does lower risk necessarily mean risk free?

What to watch for:

Given bonds’ relatively high trading costs, and with pension funds, investment banks and corporations dominating the market, most retail investors opt for mutual funds and exchange-traded funds over direct bond purchases.

Some advisers say that’s just where smaller investors should stay.

James Berman, president of investment adviser JBglobal.com and an investing instructor at New York University’s School of Continuing and Professional Studies, tells his students that individuals should invest directly only in U.S. Treasury bills, notes and bonds and their inflation-linked equivalents known as TIPS that are sold via the government’s TreasuryDirect program.

Corporate bonds, high-yielding and higher-risk junk bonds, and municipal bonds and foreign government debt are best purchased through funds, he added.

The Federal Reserve sets short-term interest rates, but its moves do tend to impact the bond market overall. The value of a bond moves inversely to interest rates on the premise that future bond issuance will bring higher yields, cutting the appeal of the old bond; falling rates raise the profile of higher yielding bonds already in circulation.

In addition to TreasuryDirect, most major discount brokerages, such as Scottrade, offer government, corporate and other bonds. Firms catering to individuals such as Fidelity Investments, Charles Schwab & Co. also handle bond investments.

The Bond Market Association, although it is the lobbying group for the industry, offers a neutral informational Web site at investinginbonds.com. There, investors can find bond investing how-to, analysis, financial news and investment calculators.

For instance, depending on the size of their investment portfolio and their tax bracket, investors may want to use a tax-yield equivalent calculator to see if municipal bonds are more advantageous than equivalent taxable bonds. Investors must also consider insured bonds versus uninsured; they offer a lower yield in exchange for protecting an investor against default.

With bond funds, investment researcher Morningstar Inc. suggests this formula to determine how much a fund stands to gain or lose based on what’s called duration — a measure of a bond’s sensitivity to interest-rate moves: For every percentage-point shift in interest rates, the fund’s value will change according to its duration.

For example, if interest rates go up by 1% and the duration of the fund is five years, the fund would lose 5%. If interest rates fall 1%, the fund would gain 5%.

What to watch out for:

Elusive pricing