There are several asset classes you can choose for your portfolio: Cash, stocks, bonds, real estate, commodities and currencies to name just a few broad categories. The key idea here is that different asset classes have different levels of risk and return, and the way you mix them in your portfolio will play a key role in determining your overall risk and return.

Risk of Bonds: Bonds tend to be less risky than stocks, which means that it offers a lower, safer return on investment. Young investors with long time horizons have a greater ability to take risk, and tend to have a smaller allocation to bonds. Older investors, on the other hand, tend to have a diminished ability to take risk, and tend to have a larger allocation to bonds.

Video: A news report on China's holdings of U.S. Bonds (Feb 22, 2009). The values of U.S. bonds are closely connected to China's demand for U.S. debt: If China stops buying U.S. debt, then bond values will decline.

Here are a few Exchange Traded Funds (ETFs) you can use to gain exposure to major bond indices.

iShares Barclays 20+ Year Treasury Bond (TLT): This ETF tracks the performance of long-term United States Treasury bonds. All of the bonds held in the fund is rated as investment grade by Moody’s Investors Service (i.e. very low probability of default on the bond). Because the fund holds long-term bonds, it tends to have a higher sensitivity to interest rate changes when compared to short-term bonds.

iShares Barclays TIPS Bond (TIP): The iShares Barclays Treasury Inflation Protected Securities Bond Fund seeks to replicate the performance of inflation-protected bonds issued by the United States Treasury. Inflation-protected bonds are identical to treasury bonds, except that principal and coupon payments are adjusted to protect the holder against the effects of inflation.

iShares Barclays Aggregate Bond Fund (AGG): The fund aims to track the performance of all investment grade bonds trading in the U.S., as defined by the Barclays Capital U.S. Aggregate Index. The bonds held by this fund are of high quality, and have a low probability of default. Another fund that tracks the performance of investment grade corporate bonds is the iShares iBoxx $ Invest Grade Corp Bond Fund (LQD), which tracks the performance of the U.S. investment-grade corporate bond market as defined by the iBoxx $ Liquid Investment-Grade index.

iShares Barclays 1-3 Year Treasury Bond (SHY): This fund tracks the performance of short-term U.S. government bonds. Because these bonds are short-term, they tend to have a lower sensitivity to interest rate changes when compared to long-term bonds. If you are looking for bonds with shorter maturities, i.e. an even lower sensitivity to interest rates, take a look at iShares Barclays Short Treasury Bond (SHV), which only invests in U.S. Treasury bonds that have a remaining maturity of between one and 12 months.

iShares iBoxx $ High Yield Corporate Bond Fund (HYG): This fund tracks the performance of high yield bonds contained in the iBoxx $ Liquid High Yield Index, which are riskier than investment grade bonds.

Recommended Reading

Bond Markets: A new economic era is dawning (The Economist)
Bonds vs. Equities: Is it back to the Fifties? (Financial Times)
China Losing Taste for Debt From U.S. (New York Times)
A new interest rate conundrum? (Allianz Economic Research)