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How to invest in bonds

By David Luhman on Sat, 05/09/2009 - 23:35

How to invest in bonds

Bonds - funds vs. individual

So now that we've looked at attributes of various bonds and other fixed income investments, let's see how you might go about actually investing in them.

First, I'd recommend that you limit your fixed income investing to mutual funds, banks or insurance companies. With the exception of US Treasuries, buying individual bonds is generally not a good idea unless you have at least $50,000 to invest in a variety of bonds.

Unless you have that much money to put into bonds, you'll lack the diversification necessary to reduce credit risk to a manageable level. Also, the secondary market in bonds for individuals is not very good, so you're better off sticking with mutual funds.

You can, however, buy your own US Treasury bonds. You can buy them directly from the US government at little cost.

But I'd stay away from US EE savings bonds. These offer poor yields and you can easily lose up to six months in interest if you aren't careful.

EE Savings bonds have minor tax advantages, especially when it comes to paying for college, but the rules are complicated and limited to lower income people. Savings bonds just aren't great investments.

Bond market is efficient - like a commodity

If you decide to use a bond mutual fund for investing, remember that bond funds offer higher yields than banks, but the bond fund will complicate your taxes. See my tape on mutual funds for more information on fund taxation.

Also, when investing in a bond fund, don't pay for a so-called hot manager who charges you high fees and justifies these fees by trying to beat the bond market.

Bonds and other fixed income investments are largely commodity products. Consider, for example, the US Treasury market.

The Treasury market is huge, and all the securities have the same, excellent credit rating. There's no reason to pay high fees for a US Treasury bond fund, yet some funds charge their investors over 2 percent in fees. These investors are simply wasting their money.

With US Treasury bonds currently yielding about 7 percent, these investors are giving up almost a third of their income. They could just as easily shift to a US Treasury bond fund that has an expense ratio of only 0.3 percent.

Watch out for temporary fee waivers

However, especially with money market mutual funds, you need to be careful that the fund's current high yield isn't the product of a temporary fee waiver. To attract new investors, many funds waive their management fees for six months or so.

This raises their reported yield, and new money pours in. After the fund has plenty of new investors, the fund raises its fees again back to its old levels.

Maybe pay more for junk bond managers

About the only time you might want to pay extra for a bond fund manager is in the area of junk bonds. Most investment grade bonds already are rated by independent rating agencies like Moody's or Standard & Poors, so it's doubtful that your bond fund manager can add value by picking out the good credit risks from the bad ones.

But junk bond investing is trickier. Here it may pay to hire fund analysts who will dig deeply to discover a company's true ability to pay off its debt.

In this case, it's more like trying to find a good stock. Still, you shouldn't pay more than 1 percent of assets to find a good junk bond fund.

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