Pros and Cons of Bond Packages vs. Individual Bonds

The Dan O’Brien versus Dave Johnson decathlon question isn’t the only controversy that’s not going to be settled once and for all this summer.

You’re also not going to get a convincing answer anytime soon as to which is better in this low-yield environment: individual bonds or bond funds. Each investment category has its own strengths and weaknesses.

Individual bonds enjoy two big advantages over funds: They offer more predictable returns, and they don’t come with annual fees attached.

If you buy a bond and hold it until maturity, your return will equal the yield or semiannual interest payments earned along the way.

That’s not the case with the vast majority of bond funds, which have indefinite life spans and are constantly adding some bonds and dropping others.

These additional transactions affect the overall yield, especially when the manager must do a lot of trading in response to heavy investments or withdrawals by the fund’s shareholders.

“The argument for holding individual bonds is that you know what’s going to happen in terms of the timing and amount of payments you receive,” says C. Frazier Evans, senior vice president of Colonial Mutual Funds in Boston.

Actually, you will only earn the predicted yield on an individual bond if you don’t sell it prior to maturity, don’t own one that goes into default and don’t have one that gets called away (prematurely retired at the issuer’s option).

Over the next three years, the call risk is a significant danger for owners of municipals issued between 1982 and 1985 at hefty rates of 8% and higher. About $200 billion worth of the tax-free investments could get called between now and 1995, Evans estimates.

But for the most part, individual government, corporate and municipal bonds--unlike the funds--offer predictable yields if held to maturity.

The other selling point for individual bonds--the lack of ongoing fees--is a clear-cut advantage. You will face a broker’s commission when buying individual bonds but nothing beyond that.

Fixed-income funds, by contrast, levy fees of between 0.5% and 1.5% a year. These expenses, which reduce the return to shareholders, cover the management company’s take as well as fund operating costs.

Funds sold through brokerages, financial planning firms, insurance agents or banks may also charge a selling commission or load.

Do fund managers perform sufficiently well to justify the fees? That depends on whom you talk to, and what kind of bond investments you’re talking about.

With high-quality bonds--those rated double A or better--there’s no need to buy a fund because the default risk is so low, argues Jim Dillahunty, president of Fixed-Income Securities, a San Diego firm.

“Why pay a manager a fee to watch your government bonds do nothing?” asks Dillahunty, whose company provides bond-market counseling to brokerages and financial planners.

According to Evans, the need for a fund manager grows as you move into riskier types of bonds. Even among highly rated issues, he says, professional managers can add value in various ways, such as finding underpriced issues or avoiding bonds they think are likely to be called.

Along with professional management, diversification is another selling point for bond funds.

If you wanted to get adequate diversification in middle- or lower-rated corporates or municipals, you might have to spend tens or hundreds of thousands of dollars.

For example, an investor would need to buy at least $100,000 worth of tax-free bonds, which sell in $5,000 increments, to get minimal diversification, Evans figures.

Even in other areas of the bond market, investors often don’t make the switch from funds to individual bonds until they have portfolios worth perhaps $50,000 to $75,000, Dillahunty says.

Bond funds also enjoy various other edges, including:

* Liquidity. You can sell shares in a mutual fund any business day. On a thinly traded individual bond, your order might not fill quickly unless you’re willing to accept a significantly lower price.

* Automatic reinvestment of fractional shares. With funds, you can plow capital gains and dividend payments back into additional shares, regardless of how small the dollar amount. You would need roughly $1,000 to buy a single government or corporate bond, or $5,000 for a muni.

* Monthly income. Most funds pay dividends monthly, while individual bonds spin off interest on a semiannual basis.

In short, individual bonds might make more sense if you’re buying governments, highly rated corporates or top-notch municipals--and plan to hold to maturity.

Otherwise, funds generally are the way to go, especially if you don’t have at least $50,000 to $100,000 to invest.

Fund Expenses What does it cost to get professional management, diversification and other benefits typical of bond mutual funds? That depends largely on the category, with global portfolios tending to be the most costly and Treasury funds, the least. Fund expenses (aside from commissions or loads, if any) are grouped together in what’s known as the “expense ratio.” The fund company subtracts this number before reporting its total return. Here are average annual expense ratios for different bond-fund groups:

Fund Expense Ratio Global 1.57% Short-Term Global 1.50% Convertible 1.26% High-Yield Corporate 1.19% Government (General) 1.14% Mortgage 0.98% High-Quality Corporate 0.81% Municipal 0.80% Single-State Municipal 0.66% Treasury 0.62%

Source: Morningstar Mutual Funds