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UVMerrit asked:
In keeping with the principles of diversifying, I am planning on purchasing some bonds or indexed bond funds for my portfolio. I
have received advice that with $100K to invest in bonds that you should build a ladder instead of using a mutual fund.
Comments?


Hello UV,
I am just a novice at this (about one year trying to figure out bonds). Faced with the same problem, I have concluded that bonds are a lot more complicated investments than equities (stocks), yield a lower return over time, take a far bigger tax hit on what you make, have more hidden fees, expenses and risks, and, as a rule, are far more difficult to figure out what you are actually making on your investment.

Their only virtues seem to be diversification, lower volatility and lower risk. Even then, I am continually amazed at the number of people who invest large sums in bonds and bond-like investments that lack diversification and are inherently volatile and risky. Perhaps there is an axiom among brokers that says "If you make an investment instrument too complicated to understand, people will flock to invest in it." Even for 'good' bonds we pay the price of lower long-term returns and all the other disadvantages listed above.

Still, despite the shortcomings, the disadvantages of bonds appear to be a fair trade for at least a small portion of most retirement portfolios--particularly if one has only saved just enough for retirement and not much more. However, there is still no reason to abandon the basic principal that one should not invest in what one does not readily understand. Nor should one pay high fees for simply buying what bonds really are--low-yield IOU's. Using that criteria, here is my own list of what I think I should NOT invest in and what I think I SHOULD consider in in this field:

THE NOTS:
individual corporate issues (nice rates, but no diversification),
callable bonds of any kind,
GNMA funds and other bond funds based upon mortages that can be refinanced,
zero coupons (including Series E savings bonds held less than 5 years),
long-term Treasuries held in a bond fund (why pay an annual fee for what you can buy directly?),
municipals (unless I was somehow blessed with a high tax bracket),
funds investing in revenue bonds (a kind of un-guaranteed municipal),
individual municipals (high tax bracket or not),
junk bond funds (anything below investment grade of BBB),
anything for which your broker gets a special 'additional' commission,
unrated bonds (no letters, no buy),
bond funds that have the name 'Unit Investment Trust,' MIT, 'Select,' or any other initial or terms you can't readily understand,
bond funds with a high (or worse, undisclosed) buy-sell spread,
variable annuities that hold bonds,
bond-like 'preferred' stocks,
bond funds with annual fees higher than 1/2%,
bond funds with 12b fees,
foreign bonds,
a large position in private-issue tax exempt bonds subject to the federal Alternative Minimum Tax,
any bond or bond fund for which you cannot readily understand the tax implications, and
any bond with a very long maturity (>15 or 20 years).

THE SHOULDS:
CD's at your local bank (shop around for the best rate),
Money Market Funds (again shop around),
I-Bonds,
TIPS in a tax-deferred account,
low-cost corporate bonds--short-term and intermediate-term,
a 'big' basket (>10 diversified companies) of individual corporate issues--if you are willing to do all the preparatory work,
Treasury Direct bills, notes and bonds if you are willing to take the lower rates they offer,
owner-financed installment sales where you are carrying the note for the buyer at a nice percentage above the market, and
low-fee mutual bond funds (look at Vanguard first).

SPECIFICS:
Ladders? A bit of work, but perhaps worth it on individual issues. I think they are okay if you understand what you are doing. It seems that that they are more appropriate for individual issues and much less important in bond funds where you have a bunch of terms maturing at once.

Indexes? To the extent that they reduce fees, why not? What bond fund manager is going to make it big by picking the 'right' bonds?

Bond funds? You bet! They get lower transaction fees, simplified paperwork, dependable income, understandable tax statements. No maturity date worries. Shop around and don't buy one with high annual fees or front-end loads.

Taxes? Invest all the 'bond money' you can in your tax-deferred accounts (401k's, IRA's, Roth's, etc) first because you are going to be taxed at the higher 'income' rate in any event. Save your capital gain generating investments (stocks) for your taxable accounts where you may even have a chance of passing your gains off to your heirs tax free under the IRS 'step-up basis' rules.

And you thought stocks were complicated. 8^)

Do I like bonds? You can probably tell I don't, but I think some are needed for my retirement portfolio. Reminds me of a story about Lawrence Welk: When once asked about 'violence in America,' he admitted that he didn't really like violins, but thought he had to have at least a few of them in his orchestra. The same with me for bonds--I'm starting to put them in my orchestra.

Good luck,

-- John
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