Diversification is one element of a sound portfolio. While stocks are an important component, bonds and their related exchange traded funds (ETFs) offer their own set of benefits, as well.

AXA Equitable defines a bond as an IOU for money loaned by an investor to the bond’s issuer.  In return, the borrower agrees to pay the investor interest at a stated rate.  One benefit of bonds is that they generally move in the opposite direction of stocks.

Bonds do offer diversification, but come with some risks, too:

• Market risk.  Market risk is generally only a concern if one plans on selling the bond before its maturity date.
• Interest-rate risk.  This risk comes into play due to the inverse relationship between interest rates and bond prices.
• Credit risk. This deals with the likelihood that the bond issuer will go into default before the bond reaches maturity.  The higher the yield of the bond, the more likely it will default.
• Inflation risk. The risk here is that the total return from bonds will not outpace inflation.

Now that investors know the pros and cons of bonds, here are a number of ways to play the bond market.

• One could look at corporate bonds, which are bonds issued by corporations.  The primary risk with these bonds is credit risk and all interest is taxed at ordinary income tax rates. A way to play corporate bonds is the iShares GS $ InvesTop TM Corporate Bond Fund (LQD): which is up 3.4% year-to-date and has a yield of 5.6%.

• Another class of bonds to look at are government bonds, which are issued by the U.S. Treasury and are backed by the full faith and credit of the U.S. government.  These generally present inflation risk and are fully taxable at the federal level, but exempt at state levels.  A way to grab exposure to these is through the iShares Lehman 7-10 Yr Treasury Bond Fund (IEF), which  is down 7.2% year-to-date and has a yield of 3.93%.

• A third way to grab exposure to bonds is through municipal bonds.  These are issued by state, county, city or local authorities and are advantageous because of their generally tax-exempt status.  A way to grab exposure to these bonds is through the SPDR Lehman Municipal Bond ETF (TFI) which is up 5.6% year-to-date and has a yield of 3.89%.

For more stories on bonds, visit our bond category.

Kevin Grewal contributed to this article.

Tags: Bond ETFs, Corporate Bonds, ETF 101, IEF, LQD, Municipal Bonds, TFI, Treasury Bonds