Bonds and bond funds look interesting again

Your Funds

Dollars & Sense

September 12, 1999|By Charles A. Jaffe

WHILE MANY investors have been wondering whether to buy stocks or invest in stock mutual funds, few folks have pondered the same question for bonds.

Bonds and bond funds have been such generally dismal performers the past few years that investors have ignored them rather than worry about how best to buy them.

However, with interest rates on the rise and many people uncertain about the stock market's ability to keep delivering big returns, this is a good time to revisit the paper-or-fund debate.

"Most people see what has happened this year and are being classic rear-view mirror investors, saying, `I don't want to be in bonds, they have been awful this year,' " says Eric Jacobson, fixed-income editor at Morningstar Inc. "But the time to buy bonds is after a long stretch of bad performance. That leads to higher interest rates, and that's where we are now."

The investing public also is at a point at which many investors want to do everything on their own. Just as some have forsaken stock funds to pursue direct ownership of individual stocks, bond investors should weigh the merits of bond funds.

A recent study by the Schwab Center for Investment Research came to the conclusion that bond funds are for investors with less than $50,000 in fixed-income investments, who can stomach some volatility in both how much income they get and the value of their principal and who want a fund's mix of convenience and professional management.

But many financial advisers say the decision should be based almost entirely on the type of bonds they want to buy.

Bonds are debt instruments; the issuer borrows your money and promises to pay it back at a set rate over a specified period of time. Safety, regular income and diversification from the risks of the stock market are bond investing's big selling points.

Buy individual bonds and you should get the bond's face value if the note is held to maturity. If you need to sell a bond before it matures, however, liquidity could become a problem; the bond market often gives a nasty haircut to investors who bail out. Pricing almost always is tricky, meaning you could pay too much to buy or get less than fair value when selling.

By comparison, a bond fund's income stream can change over time, and its share price can swing wildly based on interest rate activity. The fund never matures, so there is no guaranteed amount to be collected at the end of your rainbow.

But funds offer convenience, the ability to buy in without a lot of money, risk management on many hard-to-figure flavors of bonds, and the chance to reinvest income in a timely fashion, rather than having to wait to amass enough to buy a new bond.

Amid those pros and cons, it's easy to see why the type of assets should settle your internal bond/bond fund debate.

With U.S. Treasury bonds, for example, the only real issue is convenience. Treasuries have no credit risk and there is little professional management actually practiced here. Liquidity is no problem, because Treasury bonds are easily sold. And Treasuries can be purchased directly from the Fed, usually for much less than the fees you would pay a fund management company.

That's why Treasury bonds win out over Treasury funds.

The same can be said for insured municipal bonds, another area in which management fees often outstrip the value a manager provides.

But most individuals will never have a great grasp of how the junk-bond market works, or which mortgage-backed securities are worth owning. And not every municipal bond is plain vanilla; some have complex features and language that affect whether they are good investments. In those arenas, bond funds are the likely choice, regardless of how much money is at stake.

Jeff Grossman, an individual investor in Newton who has had to make the bonds-or-funds decision many times, says the answer is straightforward.

"What I want from bonds is something predictable, and that means holding the bonds and not funds," says Grossman. "I don't want to take my risks in bonds, so I don't have bond funds. If I was going into an unpredictable type of bonds like junk, then I'd want a manager making the decisions."

If the bond market should ever evolve to where the stock market is now, with investors feeling certain of their ability to get the latest research and data and low-cost execution of trades, these nether regions of the bond world could open up to individual purchases.

Until then, however, bond investors should continue looking for low-cost bond funds for all but the easiest of bond investments.

Says Mark Riepe, head of the Schwab Center: "If you want fixed-income exposure and know how bonds work, you may be better off on your own. But if you're in the majority of people with no idea how bonds work, stick with funds."

Charles A. Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, Box 2378, Boston 02107-2378.

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