The Bond Fund Scoop

Do you expect interest rates to rise soon? If that happens, it will cost more to borrow money and you may get a little extra on your income investments. But your bonds may lose value.

There's an inverse relationship between bond prices and yields. If interest rates rise, the prices of existing bonds drop. Why? Well, imagine you have a bond that yields 5 percent. Then rates rise, and a new bond yields 5.25 percent. If you want to sell your now-less-attractive bond, you'll have to offer a discount to compensate for the lower yield.

This is not a big deal for those who invest in individual bonds. As long as you hold the bonds until maturity, the issuer will return your entire principal (assuming the issuer is still in business).

However, if you invest in bond mutual funds, you may be in for a surprise. In 1994 and 1999, for example, a series of rate increases resulted in losing years for the average bond fund. With interest rates still near historic lows, it would seem that rates have nowhere to go but up.

Still, bond funds do have advantages. They offer diversification, they make the investment of small amounts (including the reinvestment of dividends) a snap, and they offer the potential for capital appreciation.

If you're truly after principal preservation, though, here are some considerations:

• If you have the resources and know-how, invest in individual bonds. It's easy to invest in Treasury securities, including the popular inflation-indexed I-Bond. Visit www.treasurydirect. gov to buy, commission-free. (Another good site is www.bondsonline.com.)

• Consider short- or intermediate-term bonds or bond funds. Long-term bonds are more volatile, and the extra yield you get may not be worth the risk.

• Check out bond alternatives for your short-term savings. We offer guidance at www.fool.com/savings.

Learn more about mutual funds at www. fool.com/mutualfunds/mutualfunds.htm. To get recommendations of top-notch, low-fee bond (and stock) funds, try our Motley Fool Champion Funds newsletter for free at www. championfunds.fool.com.