Over the past couple of years, investors have learned that keeping your money in a guaranteed investment like a certificate of deposit or a savings account is a virtual guarantee that you’ll only earn pennies in return.

The same has largely been true of U.S. Treasury bills and bonds, which are also guaranteed in principal by the U.S. government. So when the 10-year Treasury bond hit 4% during the second week in April, many investors grew excited. If you are one of them: Stop! Do not invest your money in bonds until you read this.

I think bonds are one of the trickiest investments because they are counter-intuitive. Because they are called “fixed income” investments, many investors mistakenly believe that the most important consideration when buying a bond is the interest, also called the “coupon rate.”

This is not true. Bonds carry a heavy interest rate risk. If rates go up—or even if there is talk that rates will go up—the price of the outstanding bonds, which carry lower interest rates, goes down.

Here’s how bonds work: The face value of each bond is generally $1,000, which is referred to as ‘par.’ When the government issues a bond, it promises to repay the face value at some set time in the future, which might be as early as next year or as long as 30 years from now. The issuer of the bond also agrees to pay the bondholder a specified rate of interest, sometimes called a “coupon.” (It’s called a coupon because bonds once had detachable coupons that the bondholder removed every 6 months and presented to the issuer to get their interest payment.)

Because of these certainties—the face value and the interest rate—bonds have long been considered a safe and predictable investment. One study showed that from 1941 to 1980, inflation-adjusted yields on 5-year Treasury bonds never beat 4%. But the double-digit inflation of the 1980s rewrote these rules. Imagine if you held a 10-year Treasury bond with an interest rate of 4%, such as those that were sold earlier this year...

Let’s suppose that the next day, interest rates doubled to 8%. (This is an extreme example, for illustration only.) Because the interest rate on your 4% bond cannot change, the price of the bond must go down to make your bond equal in value to the one selling at 8%. If you paid $1,000 for that bond and the interest rate doubles, your bond must fall in price so that it will offer a return equal to the 8% bond. So you may only be able to sell that bond for $500. True, if you wait 10 years, you’ll get your $1,000 back. But you would be losing big in the meantime because you couldn’t buy the investments that might be available at 10% or 12% because your money is locked up in this 4% bond.

Obviously, this risk is the reason that many investors choose a bond fund rather than a single bond. But if you choose a bond fund, the manager is buying and selling bonds, hoping to make a profit. You lose the guarantee that your bond will be worth $1,000 at maturity.

A simple way to demonstrate this problem is to look at your mortgage as a bond, which it is. A banker lends you money to buy a house, establishes a term for the loan and a fixed interest rate (assuming you’ve chosen a fixed mortgage.)

Suppose your banker loaned you $325,000 to buy a house at an interest rate of 5%. If mortgage rates went up to 16%, as they did in the early 1980s, your banker would be stuck with your 5% mortgage until the end of the term.

Your banker would see the value—or the price he could sell that mortgage for—plunge. But you would feel quite pleased with your deal when you saw your friends taking out mortgages at 16%. So it is with bonds. Both parties carry a significant risk.

One other important factor: The yield on a bond generally goes up with a longer maturity. The very short-term, overnight loans in the money markets have the lowest rates. The rates generally increase with maturity because, the longer the term, the more interest rate risk the bond investor shoulders. The relationship between the interest rate and the time to maturity is what bond investors call the “yield curve.” In a perfect market, it would slope gently upward toward the longer maturity. In the real market, sometimes it is nearly flat or sometimes it is inverted, which tells you something about sentiment in the bond market and how investors expect rates to move.

So what’s a smart investor to do? Some professional investors—namely those who manage money for large institutions—bought bonds when the rates spiked in early April. Others chose to sell their bonds based on the very same signal.

One of the significant sellers was Bill Gross, manager of Pimco Total Return fund, the world’s largest bond fund. The New York Times reported on April 11 that Gross’s fund, which held half its assets in U.S. government bonds 9 months ago, was down to 30% U.S. Treasuries, the lowest in the fund’s 23-year history. Gross told The Times that he was buying debt from Europe, particularly Germany, and also from developing countries like Brazil because it looked more attractive to him than U.S. debt.

Bonds are today’s “hot investment.” If you hear friends and neighbors talking excitedly about their new bond funds, remember this: Mutual fund companies, just like individual investors, tend to follow the herd. So when bond funds brought in nearly $400 billion in 2009 compared to an outflow of $9 billion in stock funds, most mutual fund companies decided to open bond funds or to open more bond funds, as reported in Fortune on April 12.

But that’s marketing. When investors and the media are talking about bonds, fund companies want to put out some new offerings to get attention. If anything, the sprouting of new bond funds is a contrary indicator, suggesting that the bond rally may be over. That’s what Pimco’s Bill Gross says. The last 25 years have been a thrilling bond rally as interest rates plummeted, Gross said. But now interest rates have nowhere to go but up, which is a poor environment for bonds.

Here’s what Fortune concludes: “It’s easy to see why money management firms would invest in bond offerings—but it’s less apparent that it’s a good move for investors. In fact, market strategists have turned bearish on bonds in recent months due to concerns that the Fed will hike interest rates.” 

Most financial advisors say that every investor should keep at least a portion of his portfolio in bonds. If you choose to follow that advice, look for a bond fund with the lowest possible expense ratio, which measures the percentage of the fund’s assets that are paid for expenses. Expenses are what make the biggest difference in a bond fund.