Q: Is investing in bonds by buying bond exchange-traded funds (ETFs) and mutual funds as safe as buying them directly from the issuer, such as the U.S. government?
A: You can get the best deal on produce, often times, by buying direct from the farmer. And sometimes you can get a better price on a used car by buying straight from the owner.
Skipping the middleman certainly can have advantages. And that can also apply when investing in bonds, especially Treasuries issued by the federal government.
While it's possible to invest in bond funds that buy Treasuries, you can often save yourself some money and gain some advantages by buying directly from the U.S. government.
By buying Treasuries directly, you can reduce the fees you pay. Even the Vanguard Total Bond Market exchange-traded fund(BND), which has one of the lowest fees in the industry, still charges a 0.11% annual expense ratio. That means you'll pay $11 the first year in fees on a bond portfolio of $10,000 — and the annual fee will rise if the value of your bonds rise.
But you can buy Treasuries free either from the U.S. government or from several online brokers. The government sells Treasuries to individuals at www.treasurydirect.gov. Fidelity and Schwab are among the online brokers that offer very reasonable pricing on Treasuries.
Buying Treasuries directly has another benefit — control. If you buy a Treasury with a face value of $1,000 that matures in 2050, you are entitled to receive that $1,000 back in 2050, plus interest payments along the way. That guarantee of return, one of the biggest benefits of bonds you buy and hold, is lost with bond ETFs and mutual funds.
When you own a bond ETF or mutual fund, you do not have a guarantee of your investment being returned. Instead, to recoup your investment you must sell your shares, for potentially less than what you invested.
While there are benefits to buying Treasuries directly, there is some convenience to buying bond ETFs and mutual funds that may be worth the small fee.
Most important, ETFs and mutual funds handle the chore of "laddering" your bonds. In other words, the fund may buy short-term Treasuries that mature in three months, plus some that mature in five years and 10-years. As the bonds mature, the fund then reinvests the money at the going interest rate.
This practice is very valuable because it helps you reduce the risk of losing out during a period of rising interest rates. If rates rise, the bond fund will add new bonds at the higher rates. Laddering is something you should do even if you own individual bonds, but bond funds do it for you.
Second, bond funds help handle diversification. By owning bonds from different issuers, you can reduce your risk of problems at any one issuer. This is a benefit when buying corporate bonds. However, when buying Treasuries there is no such benefit because all the securities are backed by the U.S. government.
Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Click here to see previous Ask Matt columns.
