Individual Bonds or Funds?

By Meg Richards
Associated Press
Sunday, April 2, 2006

Whether you are retired and living off your savings or are a young investor with decades to go before you tap your nest egg, fixed income deserves your consideration. What may be less clear is whether it's wiser to buy individual bonds or get exposure through mutual funds.

For most of us, experts say, funds are probably the better deal because they offer greater diversity at a lower price tag. Yet at the end of 2004, some 54 percent of total fixed-income assets held by retail investors were in individual bonds while only 46 percent were in bond funds, according to figures from the Federal Reserve Bank and others.

Bond investors who do it on their own will often build a "ladder" of individual securities, meaning they own bonds of different maturities to help manage risk and ensure steady cash flow. The problem with this kind of strategy is that it's high maintenance and can be costly. Transaction fees will be higher for those who have less to invest -- and in the bond world, expenses can take a big bite out of total return.

"I think it might come down to how much work you're willing to do," said Paul Herbert, an analyst with Morningstar Inc. "If you buy a ladder, you have to monitor it; you have to do the work. Every year you're going to have to make trades."

The reality is, many individual investors lack the asset size and expertise to construct a truly diversified bond portfolio, said Douglas T. McGinley, fixed-income portfolio manager for Fidelity Investments. In addition, even the most meticulously built bond ladders lack exposure to huge parts of the market, such as asset-backed securities -- mortgages, auto loans, credit cards -- which aren't generally available to individual investors.

As a result, many investors who buy individual bonds wind up taking on less risk, and sacrificing return in the process. And those who do seek out higher returns tend to take on a disproportionate amount of risk, McGinley said.

"When I speak to investors, the ones who make the argument for putting together their own portfolio of bonds will say, 'I don't need to be that diversified, because I just buy triple-A rated Treasurys or municipal bonds,' " McGinley said. "My suggestion to them is: You're giving up the return potential that comes with buying different types of securities. You're avoiding risk, but you're avoiding potential return, as well."

For most investors, bond mutual funds solve a number of problems, providing instant diversity and professional management, generally at a reasonable cost. Of course, one advantage to owning individual bonds -- and stocks, for that matter -- is that it puts you in control of when securities are bought and sold, and when capital gains are generated. On the other hand, by owning a mutual fund, you'll be turning record-keeping and portfolio management worries over to a professional.

So, if you accept that you need fixed income in your portfolio and you've decided to get it through mutual funds, what should you own? A good core fund will include exposure to corporate bonds and Treasurys of varying maturities, asset-backed securities, and possibly some high yield. It might also hold foreign or emerging-market stocks and Treasury Inflation Protected Securities, or TIPS. There are a plethora of solid, inexpensive no-load funds to choose from -- though you may prefer holding them in a tax-deferred 401(k) or Individual Retirement Account because of the income they generate, Herbert said.

If the idea of owning the entire bond market appeals to you, Herbert suggests using a fund like Vanguard's Total Bond Market Index (VBMFX) as your fixed-income anchor; it tracks the Lehman Brothers Aggregate Bond Index. Other no-load funds with strong records and low expenses include Baird Aggregate Bond Fund (BAGIX); Harbor Bond (HABDX) , managed by fixed-income icon Bill Gross; Fidelity Investment Grade Bond (FBNDX); and Dodge & Cox Income (DODIX). If you're interested in a fund that has more latitude to go into non-investment-grade issues, Herbert suggests Fidelity Total Bond (FTBFX).

Depending on the contents of your core offering, you may want to complement it with a small stake in high-yield bonds. These issues won't be as sensitive to changes in interest rates; their values are driven more by the perception of company fundamentals, much like stock. This also makes them more volatile, which is why you wouldn't want to devote more than about 10 percent of your total bond allocation to them, Herbert said. Good high-yield funds to consider include Vanguard High Yield Corporate (VWEHX) and Northeast Investment Trust (NTHEX). A well-managed multi-sector fund, such as Loomis Sayles Bond (LSBDX), could also serve a supporting role.

For retired investors who are living off their portfolios, TIPS funds can hedge against inflation risk, but be sure to check on how much you already own in your core fund. And if you've maxed out your contribution to your tax-sheltered accounts, a municipal bond fund is a fine holding for the taxable side of your portfolio, Herbert said. Even if you don't live in a high-tax state, you can augment your fixed-income core with a national municipal bond fund, such as Fidelity Intermediate Municipal Income (FLTMX).

If, as you consider bonds, you're worried about where interest rates are going, don't. Bond investors with long-term time horizons saw negative total returns only 0.4 percent of the time from 1926 to 2003, according to Fidelity. This is the last place where you should let short-term news drive your allocation decision.

"We don't advise people to be timing the market. Most people won't have long-term success doing that," said Fidelity's McGinley. "In fact, we manage our funds to maintain somewhat steady overall exposure. We're not trying to make big bets on rates. . . . It adds volatility without adding much value for shareholders over the long run."

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