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By Christine Benz and Eric Jacobson | 01-16-2014 03:00 PM

Buyer Beware With Most Individual Bonds

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

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.

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