| With the stock market skidding through a patch of volatility reminiscent of the 1990s, suddenly the bond market might look like a good spot to stash some cash.
But bonds have their own pitfalls. Whether you pick an individual issue or a bond mutual fund, you could be stepping into trouble unless you understand the fundamentals of the market.
"The bond market is one of the last remaining Wild West frontiers of the investment market because there are so many moving parts," said Tony Albrecht, director of fixed income for the Windsor Financial Group in Minneapolis. "It is very important that you understand what you're buying."
Bonds are paying a higher yield than they have in years. At the bottom of the fixed-income market in 2003, 10-year Treasuries paid 3 percent and two-year Treasuries paid a yield of just 1 percent. Now they both pay a yield of about 4.5 percent.
Municipal bonds typically pay a yield somewhat below Treasuries--currently in the range of 2.5 to 4 percent--but the interest they pay is usually exempt from federal taxes and often from state taxes. Municipal bonds are typically issued by state or municipal governments to finance public works projects, capital expenditures and general operations.
Bonds seem like a safe, straightforward investment, but many investors overlook their perils. One of the greatest dangers of bonds is the risk of default. Although U.S. government bonds are considered among the safest investments on Earth, corporate bonds and municipal bonds have been known to go into default when issuers encounter financial difficulty.
There are some other less dramatic problems, as well, that could take a bite out the long-term returns of certain bonds.
Lack of liquidity
Your broker might sell you the bond of a quaint little corporation or municipality that pays a competitive yield, but the smaller the issuer, the more difficult it might be for you to unload that bond.
"There's a big difference between the liquidity of the stock market and the liquidity of the bond market," Albrecht said. "In the stock market, you can always find a buyer for stocks you want to sell. That's not always the case with bonds. Some bonds from small issuers may not have any demand in the market, so if you want to sell that bond, you may not be able to. The larger the issue, the easier it will be to sell the bond."
Callable
Some bonds have "call" provisions that allow the issuer to recall them -- to take them off the market -- long before the bond reaches its maturity date. If you hold a bond with a call provision, the issuer can recall that bond by buying it back from you. You get all of your principal back, but you no longer receive interest payments.
Many issuers recall bonds and issue new bonds when interest rates drop so that they can pay a lower rate to the new bondholders.
"All you have is downside risk if you hold a bond with a call provision," Albrecht said. "If market interest rates go up, the value of your bond declines. But if interest rates go down, the bond would get called and you would have to reinvest your money at a lower yield."
Hidden costs
"Investors often think that they aren't paying a fee to buy a bond," said Patrick Larsen, fixed-income portfolio manager for Windsor Financial. "What they don't understand is that they are paying a hidden fee, which the broker bleeds out of the yield."
In other words, your broker might buy you a bond that has a market yield of 3.5 percent, but by the time it lands in your account, the yield you receive is more like 2.7 percent. By paying more for the bond, your relative return could drop substantially.
Where do these costs come from? If your broker doesn't have the right bond for you in inventory, he or she would have to buy it through another firm. That would incur a trading desk mark-up of 1/8 to ¼ percent. Your broker's company might tack on another 1/8 percent and your broker might add yet another ¼ to ½ percent. So by the time the bond gets to you, you've incurred hidden fees of about 1 percent.
Smart shopping
"Before you buy a bond," Albrecht said, "you need to ask your broker, what's the credit rating, what's the maturity date, and what's the call date?"
You should also compare the yield of the bond to the going rate of the market. You can find municipal bond fund rates at www.bondsonline.com. If it's above or below the market average, you should ask your broker about the discrepancy. If the bond is paying a yield higher than the market average, for instance, there's probably a good reason -- either it has a low credit rating or it is at risk of being called in the near future. The best bet, Albrecht said, is to buy new-issue bonds.
"All you would pay for a new issue is the underwriter's discount, so if you buy a $10,000 bond with a 5 percent yield, you will receive the full 5 percent."
Bond funds
Bond mutual funds also have drawbacks. For instance, in a time of rising interest rates, the value of your fund shares will almost always decline. The reason: If you can buy a bond today that pays a higher yield than an older bond, investors would be unwilling to pay full price for the older bond. If you bought a bond fund in June 2003 when interest rates hit the bottom, for example, your shares are probably worth less today than when you bought them.
Some bond funds also have front-end loads that could add an additional 5 percent or so to your purchase price. And even the no-load funds have annual fees that can chew up about 1 percent of your return each year.
Finally, some municipal bond funds tend to load up on bonds that are subject to the alternative minimum tax (AMT). Such bonds tend to pay a higher yield, but if you're subject to the AMT -- as are most affluent investors -- you would be subject to taxes on the payouts.
"Municipal bond fund managers load up on those types of bonds to juice up their perceived performance," Larsen said, "but it can really cost the investor in additional taxes."
Bonds can add some diversity and stability to your portfolio, but as Larsen puts it, "caveat emptor -- buyer beware!"
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