Bonds Are Tricky; Small Investors Need a Fund
The economy now seems ready to slip into a recession, if it hasn’t already done so. While a slump would be painful for the nation as a whole, it could eventually lead to lower interest rates, and that would benefit bond investors.
Rates might not fall sharply for several months or more, yet it’s never too early to start planning your next moves. One of your first concerns should be deciding how to invest in bonds--individually or through mutual funds.
Individual issues offer an advantage in that they have fixed maturity dates and pay a set amount of interest, usually semiannually. As a result, you can map out with reasonable certainty when you will get your principal back and how much interest you will receive in the meantime.
It’s comforting to know that your bonds will eventually pay off at face value, even if rising interest rates push down their market value in the interim. Most bond funds never mature, so you can’t really predict what they’ll be worth at some point in the future. What’s more, their dividend payments vary.
Keep in mind, however, that the best-laid plans of bond investors can be shattered by issues that default. Independent companies such as Standard & Poor’s and Moody’s rate bonds according to an issuer’s perceived ability to pay interest on time and return the principal amount upon maturity, but these ratings aren’t always fail-safe.
Only bonds issued by the U.S. Treasury and certain federal agencies are considered to have no default risk, which explains why conservative investors prefer them, even though they pay lower rates. “The very highest-quality bonds can be held individually with reasonable safety,” says Bill Westhoff, senior vice president of fixed-income management at IDS Financial Services in Minneapolis. His definition of high quality includes top, triple-A rated corporate and municipal debt.
There’s also a cost advantage to owning individual bonds rather than fixed-income mutual funds. All funds charge various operating expenses--for management, overhead, record-keeping and other services--that can be avoided with your own portfolio. Expenses average about 1% a year for taxable bond funds and 0.8% for municipal bond funds, according to Morningstar Inc. of Chicago. Considering that long-term corporates, for example, returned just 9.5% a year on average during the ‘70s and ‘80s, high annual expenses can drag down a fund.
George Chamberlin, a vice president with Prudential-Bache in Carlsbad, believes that investors are often better off putting together their own bond portfolios with the help of a broker. He considers funds inferior choices because they charge annual expenses. Also, he perceives many to have lackluster management. “Most bond fund managers are afraid of their own shadows,” he insists. “They’re devastatingly worried about guessing wrong on interest rates.”
Chamberlin argues that a person with as little as $30,000 to invest can assemble an adequately diversified portfolio of government, municipal or even corporate bonds. He suggests “laddering” or spreading out the maturities so that you always have a bond coming due in the near future. This strategy will also give you a blend of short-, intermediate- and long-term interest rates.
Chamberlin’s views aren’t shared by everyone. Bond mutual funds offer advantages of their own, and they’re preferable for most investors, proponents claim. In particular, funds provide an easy way to get wide diversification and professional management for people with just a few thousand dollars or less to invest.
Many experts question whether $30,000 can buy sufficient diversification in the bond market, with the possible exception of Treasury issues. Ralph Norton, publisher of the Muni Bond Fund Report in Woburn, Mass., feels that investors need at least $100,000 to $1 million to build a well-rounded municipal bond portfolio. Munis normally carry face values of $5,000 each, so a $100,000 stake would buy a maximum of 20 different issues.
David J. Kudish, president of Stratford Advisory Group, an investment consulting company in Chicago, recommends a minimum $1 million portfolio for either individual munis or corporates.
One problem with corporates, he says, is the possibility that a company, no matter how big and strong, could get acquired in a leveraged buyout. That would typically lead to a lower credit rating for the company’s bonds, and they could fall sharply in price, sometimes in a matter of days. Obviously, the impact on a small portfolio would be greater than on a mutual fund holding perhaps 100 to 200 issues, if not more.
In addition, funds benefit from economies of scale. They buy and sell in larger quantities than individuals--typically in what are known as “round lots”--and thus pay much lower proportional transaction fees.
When smaller investors buy or sell bonds, they typically face a broker’s commission plus another middleman fee known as a “spread.” (One exception is new bonds, for which the issuing entity often absorbs these costs.) Both commissions and spreads vary--by type of bond, size of transaction and other factors. “The further down you go in credit quality, the wider the spreads can get,” Westhoff says.
On a transaction involving a small quantity or “odd-lot” of infrequently traded, lower-rated municipal or corporate issues, the spread can approach 5% or more of a bond’s value, plus commissions, Westhoff says. Kudish warns that transaction costs for retail investors can be much higher on bonds than stocks. “If you’re an odd-lot seller, they won’t just clip your wings, they’ll clip you up to your shoulders,” he says.
A fund’s trading costs will already be reflected in its per-share price.
Then there’s the question of whether amateur investors, even with the help of a broker, can expect to do better than a professional manager. “I can understand people wanting to dabble in the stock market and buy a stock here and there, but the bond market requires another level of sophistication,” says Henry Schmelzer, executive vice president with New England Securities, a Boston-based firm that serves as the distributor for three mutual fund companies. “Bonds are more tricky and complex.”
Schmelzer says it’s not unusual for wealthier individuals to buy bond mutual funds. “Even some larger investors don’t want to be bothered with the management of their holdings and instead go the fund route.”
One of the biggest advantages of mutual funds is that they offer an easy way to reinvest dividends and any capital gains in additional shares, including fractional shares, often on a monthly basis. With an individual portfolio, you would need to save up your interest until you had enough to purchase an additional bond. “And then you have to go through the process of finding new bonds to buy,” Norton says.
In short, there’s a trade-off involved for fixed-income investors. Mutual funds don’t mature like regular bonds, nor do they pay a specific level of interest. Also, funds charge roughly 1% a year in management fees and other expenses that you won’t face with your own portfolio of bonds. But in return, you get low-cost diversification, professional management, economies of scale, convenient reinvestment and other benefits.
AVOIDING A BIG BITE ON BOND FUNDS A large up-front sales fee on a bond mutual fund can put a severe dent in your total return. This implication hasn’t been lost on fund companies. Only a handful of fixed-income portfolios levy the maximum allowable 8.5% load. In fact, most charge either no sales fees or relatively modest loads of 4.75% or less.
A survey of more than 1,330 bond and stock funds tracked by Morningstar Inc. of Chicago reveals the following breakdowns. Note that on stock funds--partly because of their greater upside potential, which can offset the effects of a big sales charge--there’s a larger proportion of full-load funds.
This chart excludes funds with back-end loads, for which the sales charge varies depending on when an investor redeems shares.
% of bond funds % of stock funds No-load funds (no sales charge) 38.1% 39.4% Low-load funds (0.25% - 3.9% charge) 6.2 9.9 Medium-load funds (4% - 4.9% charge) 42.7 18.9 High-load funds (5% - 8.4% charge) 11.8 18.7 Full-load funds (8.5% charge) 1.1 13.1 Total 100% 100%
