Bonds Or Bond Funds?

Yields are at four decade lows. Investors are looking for ways to increase income without increasing risk. The obvious way to increase yields is to reduce expenses on investments. The search for lower expenses revives the longtime debate over whether it is better to buy bond mutual funds, individual bonds, or the relatively new exchange traded funds (ETFs). Let’s examine these options.

Mutual funds are an easy way to own bonds. With one purchase you get a diversified portfolio of probably hundreds of issues. Of course, you don’t have to research all the different bond issues. You do enough research to find a good fund manager.

A mutual fund also has liquidity. Most mutual funds can be sold every day. No-load funds have no direct buying or selling costs to the shareholder.

Mutual funds have their disadvantages.

All funds charge expenses that come right out of your income. Vanguard’s bond index funds have the lowest expenses at 0.20% of assets or less. Most other funds have higher expenses, sometimes much higher.

PIMCO Total Return, the best regarded fund in the business, has steep fees. Even an institutional investor with $5 million to invest pays 0.43% of assets. For smaller investors the best deal is the D shares with expense of 0.75% and a 12b-1 fee of 0.25%. That’s a lot of expenses in a world of 4% yields. Other share classes have front-end or back-end loads of up to 4.50%. As I point out on page 3, you get the same management through Fremont Bond, with expenses of 0.57%. Many bond funds have expenses this high or higher, and have inferior performance.

When interest rates rise the value of bonds, and the shares of a mutual fund owning bonds, declines. With non-treasury bonds, the share prices can decline for reasons other than rising interest rates.

With individual bonds, that might not be a problem. You can hold the bonds until maturity and get back the entire principal unless the issuer defaults.

With a mutual fund, you do not hold individual bonds until maturity. The manager constantly is trading bonds, and you won’t know when or if the losses might be erased.

Exchange traded funds for fixed income are very new. These are closed-end mutual funds that trade on the stock exchange and must be purchased through brokers. All bond ETFs so far are index funds.

They have a couple of potential advantages over open-end mutual funds.

The ETFs have low fees that can be rivaled only by Vanguard. In addition, ETFs offer more liquidity. You can sell them any time the markets are open instead of waiting for the end of the day price settlement for mutual funds.

A potential disadvantage of ETFs is that they are not no-load. You pay a broker’s commission with each purchase and sale. If you plan to do some trading of the funds or are making regular purchases as in a dollar-cost averaging program, a no load fund might be a better choice. Another disadvantage is that the ETF won’t necessarily trade at its net asset value but will trade based on supply and demand. You might trade at a premium or discount.

Beyond that, ETFs are too new to know of advantages and disadvantages.

Direct bond purchases can avoid some of the mutual fund disadvantages.

You won’t pay a management fee off the top. You can buy new issues and hold them to maturity. You will capture the entire yield and won’t care about market fluctuations.

Purchasing treasury bonds directly is easy and inexpensive. You can buy directly from the treasury and have virtually no expenses. Check out www.treasurydirect.gov or call 800-722-2678. With treasury bonds, you don’t need to diversify. You decide which maturity bonds you want and put in your bid for the next Treasury auction. The best way to invest in treasuries is to create a ladder. This is a portfolio of bonds that mature in different years, so that your bonds won’t all mature at the same time.

Treasury bonds, however, pay meager yields these days. To get a higher yield, you have to buy corporate or state and local bonds. There is more involved with buying non-treasury bonds and more potential disadvantages.

Generally, you cannot contact an issuer and buy the bonds directly. Almost all corporations and governments use brokers and investment bankers to sell their bonds. Here are some points to consider before buying individual corporate and tax-exempt bonds.

Know the markup. Most brokers say they sell bonds without commission or for only a modest fixed fee. In fact, brokers buy bonds themselves and sell them to customers. The difference between what the broker paid and what you are charged is called the spread or markup. This can vary from 0.25% to 3% of the bond’s value. The markup varies based on demand for the bond and the amount you buy.

You need to check prices from more than one broker every time you buy a bond. You’ll learn that some brokers won’t quote a particular bond while quotes from the others will vary considerably. The broker’s inventory and the amount you are buying affect the price.

The Internet makes it easier to evaluate prices. At www.investinginbonds.com you can find unofficial prices for most corporate bonds and for tax-exempts that trade at least four times a day. A web broker with straightforward data on its markups is www.csfbdirect.com. You can go to www.munidirect.com for quotes on tax exempt bonds.

Buy new issues. For a new bond issue, everyone should pay the same price to each broker. Instead, of a markup, there is an underwriting fee built into the issue. Everyone is supposed to pay the same price on the first purchase. Then hold to maturity and collect the principal.

Buy big. If you aren’t buying new issues, you need to buy at least $100,000 of a bond to avoid paying a big markup. Even with that size of a purchase, you are likely to pay more than an institutional investor that has a trading desk. If your portfolio isn’t big enough to buy a diversified number of issues in at least that price range, stick with funds or ETFs.

Also, buy big issues. Even if you don’t plan to sell the bond before maturity, you probably will sleep better knowing that if cash is needed the bond can be sold fairly quickly at a reasonable price. Smaller issues, especially in tax exempt bonds, can take some time to sell. You have to wait for a buyer who wants the issue. A small issue frequently pays a higher yield; that’s the reward you get for buying a bond you’ll have difficulty selling.

Beware of calls. Most corporate and tax exempt bonds can be redeemed by the issuer early, known as a call. The only yield that counts, then, is the yield to the first possible call date. Don’t think you are locking in a 15-year yield if the bond can be called in five. That’s important if you are comparing yields on different bonds or planning a ladder.

Diversify. Any time you don’t buy treasuries, you have to diversify among issuers and industries (or geographic regions for tax exempts). We know from history, especially recent history, that even what appear to be the most secure bond issuers can deteriorate very quickly.

Individuals who decide to buy individual bond should buy only investment grade corporate and tax exempt individual bonds. High yield and other bonds aren’t liquid enough for individuals and are traded within a small community of institutional investors and traders. Outsiders and small investors are likely to get clipped.

Mutual funds and ETFs offer instant diversification, professional management, liquidity, and probably get better prices for bonds than you can. They charge extra fees, and there is a risk of principal loss. You also don’t really know what is in the portfolio.

Individual bond purchases are simple, have no management fees, and your principal is secure if the issuer doesn’t default.  The portfolio will be less diversified, probably resulting in greater risk. You will have to do research yourself and are likely to pay more for bonds. When the bonds mature, you might have to reinvest for lower yields. Buying individual bonds will take more of your time.

Decide which features are more attractive to you, then pick a bond investment strategy.