FUNDS ARE RECOMMENDED FOR MOST INVESTORS EXCEPT WHEN BUYING U.S. TREASURY SECURITIES
By Rachel Koning Beals
MarketWatch
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 over direct bond purchases.
James Berman, president of investment adviser JBglobal.com and an investing instructor at New York University's School of Continuing and Professional Studies, 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 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 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 http://investinginbonds. com.
Depending on the size of their investment portfolio and their tax bracket, investors may want to use a tax-yield equivalent calculator to see if municipal bonds are more advantageous than equivalent taxable bonds. Investors must also consider insured bonds vs. uninsured; they offer a lower yield in exchange for protecting an investor against default.
With bond funds, investment researcher Morningstar suggests this formula to determine how much a fund stands to gain or lose based on what's called ``duration'' -- a measure of a bond's sensitivity to interest-rate moves: For every percentage point shift in interest rates, the fund's value will change according to its duration. For example, if interest rates go up by 1 percent and the duration of the fund is five years, the fund would lose 5 percent. If interest rates fall 1 percent, the fund would gain 5 percent.
Watch out for elusive pricing, though. 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.
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.
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 low yields were 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.
Although stocks historically return more than bonds over time and so are usually rare in younger investors' portfolios, volatility can make stocks inappropriate for meeting shorter-term investment objectives such as a mortgage down payment or college tuition.
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 bonds, by most guidelines.
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