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How to Invest in Bonds

NEW YORK ( TheStreet) -- If you're upset about the mutual fund scandals, then vote with your portfolio. The bond sector is a great place to start a do-it-yourself portfolio, especially for municipal and government bonds. Most of the supposed benefits offered by mutual funds are not that valuable for larger portfolios.

Diversification of credit risk

Lowering risk through a diversified portfolio is a central issue for investing in equities. But it's nonexistent for Treasuries and agencies, and it's essentially irrelevant for rated municipal issues. Last year, Moody's reviewed the default history of the 777,746 ratings it issued for 28,099 separate entities from 1970 through 2000. There were a grand total of 18 defaults, 10 of which were for hospitals. These rates of default are substantially below the default record of Aaa-rated corporate bonds.

The review noted that "General obligation and essential service water, sewer, schools revenue bonds have been particularly safe investments. No Moody's-rated issuer defaulted on any of these securities during the sample period." Moody's did note that three short-term note issues, most notably those of New York City and Cleveland, were not paid on time.

However, even in those cases, financial restructuring created state-sponsored bonds, which refinanced those notes and their outstanding interest in full. Unrated municipal debt issues were not studied, but Moody's said "there were substantially more unrated defaults during the same period." As long as you are buying investment-grade, regular (not corporate-backed) munis, there is no demonstrable benefit to diversification.

If you are focused on Treasury or agency debt, issued by Fannie Mae (FNM), Ginnie Mae or Freddie Mac (FRE), once again there is no credit-related reason to worry about diversification.

Costs

Given the level of initial sales fees, ongoing management fees and expenses in most bond funds, it can be a bargain to assemble your own portfolio. You probably need a minimum of $50,000 in munis, less in Treasuries, to make it worth your while. As I've written before, the best time to buy municipal bonds is when they are newly issued. In the initial offering period, the issuer -- the state or county, for example -- pays the broker, not you. In addition, at that point, you're assured of getting the same price as all other investors. Call your regular broker and ask him or her to keep you informed about upcoming new issues that fit your needs.

In the secondary market you will pay a commission, and it helps to do some research on general pricing unless you're comfortable with your broker. The industry and regulators are currently arguing about how to get better price information widely available.

For now, log on to the site sponsored by the Bond Markets Association for recent rate information. If you live in a higher-tax state, look for issues that capture as many of the benefits of the tax-exemption as possible.

If you are buying U.S. Treasuries, you should use Treasury Direct, the aptly named direct-purchase system. Once you open an account, you can purchase online, by phone or mail, and even roll over your maturing issues into new issues with ease -- and without fees.

As for agency debt issues, every firm has them. Transaction fees should be quite low, and pricing information is readily available. Your broker may want to talk you into something else, but most diversified bond portfolios include some boring agency debt. But why pay a fund manager to pick them for you? It's just not that hard.

Interest rate risk

Most investors are scared of this and thus hand the job over to the professional. But the truth is that the pros don't know any more than you do. I've recently suggested that interest rates will probably rise because of outsize U.S. government financing needs and the economic recovery and related inflation. I think I'm right, but that doesn't mean I can tell you when, by how much, or how fast rates will turn down again. And I don't think your bond fund manager knows either.

The basic interest rate risk is loss of principal from interest rate changes. In a mutual fund, when interest rates change, the value of your shares changes daily. So as rates rise, the value of your mutual fund holdings will decline. Of course the resale value of actual bonds in your portfolio would also decline when rates rose, but if you hold bonds to maturity, you will be paid in full. And you can control the timing of any sales and related tax issues to match your own needs.

If you're looking for fairly steady returns over time without too much exposure to changes in interest rates, you need to build a "ladder" -- an old-fashioned concept that my grandfather perfected in his municipal bond portfolio. It means that, over time, you buy bonds that mature each year for the next 10 to 15 years. Then, each year, when bonds mature, you replace them at the then-prevailing rates. So in any given year, your portfolio is not overly exposed to changes in prevailing interest rates.

If rates are high, you'll capture some high-rate bonds. When rates are low, your portfolio will acquire some of those. In a period of historically lower rates, as we're currently seeing, you may want to stay a little shorter, adding bonds in the two-to-five-year range. Then when rates seem higher again, perhaps you can extend the maturity a bit. The key is to not outsmart yourself and admit that nobody knows where rates will be two years or five years from now. A laddered portfolio limits your reinvestment risk in any given year.

Liquidity

This is the one area of distinct advantage that a mutual fund has, but do you need it for your whole portfolio? Every mutual fund has the ability to redeem. You need to check fees and penalties, but it will certainly be easier and probably cheaper to redeem mutual fund holdings than specific bond holdings. But how much liquidity do you need? If you have money market funds, large-cap stocks and stock mutual funds, do all your bonds have to be extremely liquid? Look at your whole portfolio, evaluate your liquidity needs, and then decide. Don't pay mutual fund fees to get liquidity you may never need.

To protect yourself further, you can make your bond portfolio more liquid. Treasury Direct will sell your Treasury notes and bonds for you through the Federal Reserve system -- how's that for best execution? The fee is $34, but that's probably less than the haircut you may take from a broker. For munis and other bonds, the rule of thumb is a minimum $25,000 lot to get a decent resale price. Smaller pieces are harder to resell, and they may hurt your pricing.

Finally, if you want to invest in illiquid or exotic debt instruments, you should definitely look for a professionally managed fund. International debt, distressed securities (defaulted or likely-to-default bonds) and complex convertibles all have attributes that make them much more difficult to understand from a credit and pricing perspective. I don't buy them, but if you go that road, you shouldn't travel alone.

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