CHICAGO — Bonds are typically seen as a lower-risk accessory to a stock portfolio, a cardigan sweater tossed over a party dress.
Yet bonds leave many investors scratching their heads: How much of an investment plan should be allocated to fixed income? Are bonds only for those nearing or in retirement? How can performance be tracked? Does lower risk necessarily mean risk free?
Given bonds' relatively high trading costs, and with pension funds, investment banks and corporations dominating the market, most retail investors opt for mutual funds and exchange-traded funds (ETFs) over direct bond purchases.
Some advisers say that's just where smaller investors should stay.
James Berman, president of investment adviser JBglobal.com and an investing instructor at New York University, tells his students that individuals should invest directly only in U.S. Treasury bills, notes and bonds and their inflation-linked equivalents known as TIPS that are sold via the government's TreasuryDirect program.
Corporate bonds, high-yielding and higher-risk junk bonds, and municipal bonds and foreign government debt are best purchased through funds, he added.
The Federal Reserve sets short-term interest rates, but its moves do tend to affect the bond market overall. The value of a bond moves inversely to interest rates on the premise that future bond issuance will bring higher yields, cutting the appeal of the old bond; falling rates raise the profile of higher yielding bonds already in circulation.
In addition to TreasuryDirect, most major discount brokerages, such as Scottrade, offer government, corporate and other bonds. Firms catering to individuals such as Fidelity Investments and Charles Schwab also handle bond investments.
The Bond Market Association, although it is the lobbying group for the industry, offers a neutral informational Web site at investinginbonds.com. There, investors can find bond investing how-to, analysis, financial news and investment calculators.
Elusive pricing
The challenge of bond investing is aggravated by the fact that unlike stocks, there's really no easy way to check daily prices of individual bonds. Still, pricing has become clearer.
The National Association of Securities Dealers' Web-based TRACE corporate bond tracker now provides data at a slight delay.
The Municipal Securities Rulemaking Board has beefed up its municipal pricing for free. BMA's investinginbonds.com also offers municipal and corporate bond pricing. And government-debt auction data is available on the Treasury Department Web site at www.treas.gov.
But because many bonds aren't actively traded, it can still be difficult to find a specific issue's market value at a given moment.
Treasury-market trading does reflect the investing climate surrounding bonds, but how an individual bond performs hinges on many other factors: price paid, time until maturity, economic and interest-rate outlook, and whether an issuer can redeem, or "call," its debt ahead of schedule. Inflation also plays a role; it eats away the value of your bond income.
Bonds may have a lower-risk reputation compared to other investments, but they're not risk free. According to Berman, three specific risks must be considered:
Default risk: The chance that an issuer won't pay interest or the principal upon maturity; the higher the risk, the more an investor demands in yield compensation. Credit ratings on bonds assign a value to default risk.
Interest-rate risk: The possibility a better rate will make your bond less attractive.
Reinvestment risk: Whether you'll be able to roll bond returns into an investment with a similar or better yield; this usually comes to bear in a deflationary environment.
Fees take a bite
Expenses cut bond returns even more than with stocks. Bonds are usually low-risk, low-return endeavors. The recent climate is a prime example, where single percentage-point returns were about the best available.
David Twibell, president of the wealth-management division at Colorado Capital Bank in Denver, suggests buying funds with expense ratios no higher than 0.30 percent. If costs are higher, make sure the fund's performance more than makes up for it.
"It's very difficult to differentiate yourself as a bond manager," he said. "You can pick up a few basis points on yields here and there, but it's not like the hands-on nature" of a stock-fund manager.
Diversification is key
Diversification applies to types of bonds and maturities. One popular strategy to cut duration risk is to "ladder" a bond portfolio, said Kevin Cronin, chief investment officer at Putnam Investments' fixed-income group.
In a laddered portfolio, investors spread risk across a range of maturities. The diversity also extends to the holdings. Consider the financial trouble for Ford and General Motors, both longtime bond-portfolio staples.
"You can never know when the next Enron or WorldCom might come," Cronin said.
Age-appropriateness
Although stocks historically return more than bonds over time, volatility can make stocks inappropriate for meeting shorter-term investment objectives such as a mortgage down payment or college tuition.
Individuals need to decide how much bond exposure is best for their age. Retirees are likely to have half or more of their investments in bonds; 40- to 50-year-olds are likely to have 20 percent to 60 percent; and 30-year-olds might have little or no investment in bonds, by most guidelines.
Bonds can also protect a portfolio against market volatility, said Bill Zox, co-manager of the Diamond Hill Strategic Income Fund.
The 39-year-old Zox added that his own investments include bonds as a means to preserve capital during periods of stock-market disappointment. That bond-generated capital, he noted, can then be funneled into stocks as fortunes turn.
