5 Reasons to Avoid Buying Bonds Directly

When a new client hires me, he or she often comes with a handful of individual municipal or corporate bonds. I immediately go to my brokerage account and put the bonds out for bid. A day later, my client and I get the sorry news: Almost invariably, buyers offer 3% to 5% less than the bonds are worth. No professional wants to buy the relatively small bond pieces that individual investors own, so no one offers remotely fair prices.

This raises the question of why so many investors buy individual bonds rather than putting their money into bond funds. One major reason is that brokers push individual bonds, telling clients that mutual funds are for small investors, not for them.

In truth, holders of individual bonds aren't exactly complaining — or breaking down brokers' doors to unload their holdings. Instead, they're crowing about the steady income they're earning. They'll continue to get those payouts, they say, regardless of what foolishness erupts in the bond market. And as long as they hold their bonds to maturity, they'll get their entire principal back — except in the unlikely event that a bond issuer defaults.

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What's more, many investors hold seasoned bonds that they bought years ago. Many of these pay 5% or more on their initial investment. How could a fund, whose price and yield change daily, beat that?

But particularly now, with yields microscopic, owning individual bonds is the wrong thing to do. Why? Because bond yields will rise, probably dramatically, when the Federal Reserve begins backing away from the easy-money policy that has driven interest rates down to record lows. That will pummel bondholders because bond yields and prices move in opposite directions.

Yes, holders of individual bonds will continue to collect their coupons. But when yields rise, inflation normally does, too. The after-inflation return on individual bonds will turn sharply negative.

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Remember 1980? Those of us with a few gray hairs do. The consumer price index rose 13.5%. A hapless investor who had purchased ten-year Treasury bonds in 1977, when they yielded 7.5%, lost 6% after inflation in 1980 alone.

That after-inflation loss came just one year from the end of a 35-year-long bond bear market. During the 1970s and early 1980s, as yields skyrocketed and prices plunged, bonds came to be known as “certificates of confiscation.”

Given that most bond funds are likely to lose value when rates start to rise, why is a fund any better?

1. You can sell a fund at net asset value five days a week. When bond yields start to spike, I intend to unload my intermediate- and long-term high-quality bond funds.

2. Managers can use derivatives to adjust the sensitivity of their bond funds to changes in yields. One of my favorite funds, Metropolitan West Unconstrained Bond M (symbol MWCRX), should lose little or nothing when rates rise because it's deploying some of its assets to sell Treasuries short — that is, betting that they will fall in price. (The fund is a member of the Kiplinger 25.)

3. A bond fund can take risks that would be imprudent for an individual investor. If you own five or ten individual bonds, you can't afford for even one of them to go bust, so you have to stick to the highest-quality issues. But if you're a fund manager and you own hundreds of issues, it's reasonable to take some risks on at least a portion of them in return for higher yields.

4. Managers have at their disposal analysts who are much better equipped to dissect an individual bond than you are. Come to think of it, fund analysts generally do a better job of assessing a bond's safety than the pathetic bond-rating agencies do.

5. Whatever value is left in the bond market today — and there's precious little — can be found only in debt that few individuals are capable of analyzing on their own. I'm referring to high-yielding junk bonds, emerging-markets bonds and some mortgage securities. For these, you need the diversification and, yes, the professional management that a bond fund provides.

If you already hold individual bonds, I encourage you to get quotes on them. You might be able to get decent prices on Treasuries and some corporate bonds. But if you get quotes on bonds that are 3% to 5% below fair value, you face a tough decision. You can sell at an outrageously low price or cross your fingers, hold the bonds until they mature and hope that inflation hasn't eroded their value substantially. If you own short-term bonds or bonds likely to be called (that is, redeemed early) relatively soon, you should hold them. As for long-term issues, you should probably hold your nose and sell. Prices may never be higher than they are today.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.