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Buyer Beware With Most Individual Bonds

Sat, 1 Feb 2014

Individual investors can do OK buying individual Treasury bonds, but pitfalls proliferate in other credit sectors, says Morningstar's Eric Jacobson.

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Video Transcript

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Concerned about rising interest rates, many investors are opting to buy individual bonds versus bond funds.

Joining me to discuss that strategy is Eric Jacobson; he's a senior fund analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: I'm glad to see you, Christine. Thanks.

Benz: I wanted to tackle this question; it's one I get from investors, especially retired investors, a lot. They hear about what's going on with interest rates, and they say, forget bond funds. I am going to invest in individual bonds and hold them until maturity. That way, interest rates can do what they're going to do, and I really won't be bothered by them.

Let's discuss that strategy. Are there any bond sectors where you think it's fine to go ahead and buy individual bonds?

Jacobson: First off, you need to understand that volatility is still going to be there if interest rates fluctuate. You just may not notice it because you're not looking at your account. Those Treasury bonds are going up and down in value all the time if interest rates are moving around. So, even if you go that route, keep that in mind.

That said--Treasury bonds, that's the place that I would most strongly consider buying bonds directly. Even if you buy them through most brokers, the fee they charge you is de minimis, and there is no credit risk for you to really have to analyze. There are no options associated with Treasury bonds; they don't have call features or put features. So, it's a pretty simple instrument. You don't have to worry about getting hosed on price, and that's what makes it the ideal choice for individual bond buying.

Benz: How about other types of government bonds--Ginnie Mae bonds, for example, or maybe even TIPS. I hear about individual investors buying TIPS as well.

Jacobson: I throw TIPS in a little bit with Treasuries. I don't think that there is so much value that a manager can really add, especially not with an expensive fund, although PIMCO has done a pretty good job historically with its Real Return Funds.

But there is an issue of pricing. If you just purchase it through normal channels, as long as you get it either through the government or through a dealer that's just going to charge you a fee for it, you can probably do OK. Just keep in mind that understanding the pricing and so forth is a little bit tricky, because of the accrual that you have for inflation.

One thing that is helpful to some investors is that mutual funds will actually pay out the amount of the accrual, whereas an individual TIPS bond rises as the bond ages and inflation occurs, but you still have to pay taxes on that accrual even though you're not necessarily kicking it out. For some people that's probably a pretty small matter.

Again, TIPS, are a relatively OK place to [buy individual bonds]. It's probably worth buying a cheap Vanguard fund, frankly, if you just want to get basic TIPS exposure, but probably no strong reason not to buy them yourself.

Benz: I want to talk about the logistics of this and potentially the opportunity cost that could exist for some individual bond buyers. If they buy and hold a bond until maturity, say rates go up in the meantime. They may have some opportunity cost because they have held that individual bond.

Jacobson: That's right. It's very hard to speak about it in an academic way because of the fact there are so many paths that interest rates can take, so many choices that a manager may or may not make as things are happening. But by and large, as you suggest, if you have a diversified portfolio of bonds and a professional manager, there will be opportunities in the future, potentially if bond market yields do rise, to go ahead and swap things out, take tax losses on bonds that have lost some money, and then acquire bonds with higher income streams.

Benz: So, that would be an advantage that maybe a bond-fund holder would have--that manager would have a little bit of flexibility along the holding period; whereas, the individual bond buyer wouldn't have that same flexibility.

Jacobson: Especially if they're planning on holding until maturity, absolutely.

Benz: I'd like to discuss some of the costs involved in buying individual bonds, because I know that you think that's an important consideration. There are explicit costs, as well as costs that may be a little explicit. Let's discuss some of them, so that investors are aware of what they should be looking at if they are considering buying individual bonds.

Jacobson: As I mentioned with Treasuries, there is a very simple, usually fee-based, a transaction cost to buy the bond. I don't think you have to pay one, if you buy them directly from the government. I know that they're changing the program a little bit.

The problem with most [other] bond sectors, though, is that you are purchasing the bond at a marked-up price. The dealer that you're buying it through is going to receive some sort of profit on that, from what they originally purchased it, or even when they make the transaction. They'll buy it a little cheaper, if they buy it in the secondary market, and they'll sell it to you a little more costly.

The problem is that, if you're a small investor especially, you will pay the highest spread. You will pay the most of anyone when that transaction takes place. Whereas, if you're able, for example, to purchase $50,000 or $100,000 in bonds at a time, certainly over $1 million, you get the most optimal pricing, and traders who traffic in those spend a lot of effort going around to different dealers, playing them off of each other, and making sure that they're getting as good a price as they possibly can. That's really, really hard to do as an individual.

Benz: Are there categories of bonds where those costs tend be especially punitive?

Jacobson: Normally, I would say, that goes up with complexity and credit risk. But one of the big problems, certainly in the municipal bond market is that it's fragmented. It's very illiquid generally. A lot of bonds are floated by smaller regional dealers, and not necessarily supported by the big broker-dealers. All these things conspire against the small investor.

The government has some websites where you can see recent pricing that took place on municipal bonds, if trades actually occur. But with the number of municipal bonds out there and the diversity, it's going to be very hard to use that information as an individual very effectively. Even if you are able to see a better price that took place when somebody transacted it, getting a similar price as an individual is going to be very, very difficult.

You're going to be calling around to different brokers, theoretically. So, if you have your own single broker, you're going to get whatever that broker is going to be able to provide. Chances are, their shop is selling a particular series of bonds, maybe they have an inventory, or they had something to do with it, and getting an advantageous price as a municipal investor is going to be really, really hard.

Benz: Eric, you mentioned U.S. government bonds may be an OK place to go out and do your individual bond buying. A lot of investors think of AAA corporates in that same realm. This is a safe place to just go buy that Johnson & Johnson bond, or whatever it might be.

What's your take on that question? What should individual bond buyers know if they're venturing into the corporate sector?

Jacobson: Unfortunately, there aren't that many AAA issuers out there anymore. You still have some credit risk. Now we're starting to split hairs a little bit, but I'm always concerned about the fact that individuals don't usually have the time or inclination to do the credit research necessary. So you say, Eric, what if it's AA or AAA? I don't really need all that credit research. But then the question is, well, how do you know how much to pay, though? Because even if it's theoretically a AAA corporate bond, it's still going to trade, in theory, at some spread, some higher yield, over a Treasury bond of similar maturity. That spread will change every day, depending on how the market is trading. Sometimes it's very tight, as we say, or very close to the Treasuries; sometimes it's a lot wider.

If you don't know the market at that time, you don't know what other investors are paying, you're going to have a hard time not getting fleeced by the broker when you go to make that purchase. Again, that's just a very simple issue; there are others that we've talked about before--call features, etc.,--that make it even harder.

Benz: So, your main takeaway is, if you're an individual investor, you're OK buying individual Treasury bonds, but with other bond sectors, you really ought to know what you're paying, and you really ought to be prepared to do your homework.

Jacobson: Frankly, I know that a lot of people don't like that advice. They really like to buy their own individual bonds. Are you taking a massive risk by doing it? Probably more so if you're buying in high-yield. But I've heard people complain to me before: Well, I bought this municipal, or this bucket of them, and they all got called away. Even if that happens and you're OK with that happening, you want to make sure you get paid for that option, so if it does get called away, you got paid enough to begin with to make up for the fact that that could happen to you.

Benz: Eric, this has been a hot topic. Thank you so much for sharing your insights on it.

Jacobson: I'm happy to do it Christine. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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