Yahoo Finance 5 Bond Myths Investors Should Know
Investing is often made more complicated than necessary by the financial media and the self-styled "experts" featured in its coverage. So maybe it's not surprising that, for many investors, bonds are a commonly misunderstood subject, because they really are even more technical and confusing than stocks.
Investors have many choices when deciding how to invest the bond portion of their portfolio. They can purchase individual bonds (and use those bonds to build a laddered portfolio), actively managed bond funds (where the fund manager attempts to beat the risk-adjusted returns of a designated index), bond index funds (where the fund manager tracks the returns of a designated index) or a laddered bond fund.
A bond ladder involves purchasing individual bonds with staggered maturities. An example would be a portfolio with bonds that mature each year for the next 10 years. You can use the proceeds from the bonds as they mature, together with the accumulated interest, to purchase more bonds, also with staggered maturities.
Here are some common myths about bonds you should take into consideration when deciding how to invest the bond portion of your portfolio:
1. It's wise to purchase individual bonds through a broker. Buying individual bonds through a broker is usually a bad idea. According to Jared Kizer, director of investment strategy for The BAM ALLIANCE (with which I am affiliated), in a 2013 article for Multifactor World, purchasing bonds through a broker is "fraught with conflicts of interest, poor advice, undiversified portfolios and hidden costs."
According to S&P Dow Jones Indices, the average spread (the difference between the rate at which a broker buys and sells a bond) on a $100,000 municipal bond traded in the secondary market is 1.73 percent, but it can be as high as 5 to 6 percent. Compare that cost to the expense ratio of Vanguard's Intermediate-Term Tax-Exempt Fund Admiral Shares, which is only 0.12 percent.
It's no wonder, then, that ethical advisors strongly recommend investors with bond portfolios of less than $500,000 purchase a bond index fund with a low management fee, rather than buying individual bonds from a broker.
2. In order to be properly diversified, you need to own a large number of bonds. Many investors, and even some advisors and brokers, believe that owning a large number of individual bonds, or a bond mutual fund, is necessary to achieve the appropriate level of diversification.
Although diversification is essential in the stock portion of your portfolio, if you own only the highest-quality bonds, broad diversification, like what you find in a mutual fund, is of lesser importance. The highest-quality bond you can own is a U.S. Treasury bond. There is no need to diversify that risk, or the risk of owning certificates of deposit, or CDs, insured by the Federal Deposit Insurance Corporation, as long as you stay within the FDIC limits.
Even though municipal bonds are not as secure as Treasury bonds, the rate of default on AAA/AA-rated general obligation or essential service revenue municipal bonds has been exceedingly low. For example, even in the Great Depression, the losses on these bonds were no more than a few basis points. In the recent financial crisis, there were no default losses on these high-quality bonds.
According to Kizer, once your bond portfolio is $500,000 or more, diversification across issuers is "easily achieved." By owning individual, high-quality Treasury bonds, or municipal bonds such as those I have described, you will save the expense ratio charged by bond mutual funds. Even if this expense ratio is low, it does lower your returns.
3. Bond mutual funds can purchase bonds at a lower cost than you can. It's certainly true that buying individual bonds through a broker will cost you significantly more than owning them in a bond index fund. However, some registered investment advisors are able to get the same kind of pricing for their clients as those obtained by institutional investors.
Fully disclosed, transparent markups (from dealers) can average as low as 0.1 percent to 0.2 percent of the price. For bonds with an average maturity of five years, the effective cost is only about two to four basis points in yield to maturity.
These advisors are also able to purchase bonds in "odd lots," at amounts such as $25,000 or $50,000, which institutional investors tend to avoid. These odd lots typically trade at higher yields, ranging from a typical 15 to 20 basis points in yield to as much as 80 to 90 basis points. This is another benefit for those willing to trade off some liquidity, and most investors don't need liquidity for their entire portfolio.
4. Bond mutual funds are tax-efficient for all taxable investors. A bond fund does not afford the same opportunities for tax customization as holding individual bonds. Kizer uses an example involving a California resident who wants to own California municipal bonds because of their double (state and federal) tax-exempt status. In exchange for the tax benefit, the yield is lower than municipal bonds without the double tax-exempt status.
A resident of Missouri may want to limit exposure to California municipal bonds because better risk-adjusted returns from other issuers are available. Bonds from low-tax states such as Florida, Texas, Washington and Nevada typically carry higher yields because there is less demand from local residents for the double tax-exempt status. It would be possible to satisfy the needs of both investors with a portfolio of individual bonds, but it would be very difficult to do so with bond funds, as most bond funds are national or state specific.
Finally, a municipal bond fund will never buy a taxable bond, even though it may be in the best interest of a particular investor. For example, over this past year there were times when short to intermediate-term CDs provided higher after-tax returns for higher-bracket investors than municipal bonds. A competent advisor using a portfolio of individual bonds can customize that portfolio to take advantage of these opportunities.
5. Investors must choose between bond mutual funds and individual bonds. Assuming you can purchase individual bonds in a fully transparent manner (which excludes buying them from brokers) there is no universal rule to determine whether you should own bond index funds, individual bonds or both. Variables to consider include the size of your bond portfolio, your need for diversification and your liquidity requirements.
In order to determine which, or what combination, is appropriate for you, consider consulting a registered investment advisor who offers both options.
Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read.
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