Bonds Primer: Bonds or Bond Funds?

This piece, on bonds vs. bond funds, focuses on Treasuries, other U.S. government bonds and investment-grade corporates and municipals. It does not address high-yield, foreign or mortgage-backed bonds, as individual investors are best off buying these through funds.

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If you're considering buying Treasuries, other U.S. government bonds or investment-grade corporates or municipals, you can buy either a bond fund or individual securities. A simple choice, right? You wish.

The most basic distinction between buying individual bonds and bond fund shares is safety of principal. Buy a bond and, provided the issuer doesn't default, you can count on getting the full face value back on the day the bond matures. A bond fund, by contrast, can't guarantee that your shares will be worth as much when you go to sell them as they were when you bought them.

But that difference is only the beginning. Broadly, the main disadvantages to buying individual bonds is that it takes a lot of money -- tens of thousands of dollars, at the very least -- to build a diversified portfolio of non-Treasury securities that's not hobbled by high, and hidden, transaction costs. (We'll come back to Treasuries later.)

In bond funds, the main disadvantage besides principal instability is the expenses. But beyond that, bond funds have their benefits. Fund expense ratios are fully disclosed, and it's possible to pick funds with expenses that are lower than the standard broker's markup. Also, with funds you get broad diversification for a relatively small amount of money, automatic reinvestment of coupon income and daily liquidity.

Having said that, the final decision depends largely on the kind of bonds you're buying and the amount.

Treasuries

If you're interested in only Treasury securities, it's hard to make an argument in favor of bond funds. They offer the advantages we just covered, but on the cost front, it's hard to beat Treasury Direct, where basically there are no costs.

After opening an account, you can buy Treasury bills, bonds and notes at auction, at whatever yield is determined at the auction. The program requires only that you have a bank account for direct deposit purposes, and charges a $25 maintenance fee on accounts with a face value of more than $100,000.

The minimum face value on all investments is $1,000, and since September 1998, investors have been able to place orders via the Internet.

You can diversify your portfolio among different maturities by buying a combination of two- , five- and 10-year notes as they are issued. (Throw in the 30-year bond if you can stand the volatility.) If you need to sell securities, you can transfer them to a brokerage account, or for $34 the program will solicit bids and sell to the highest bidder.

Other U.S. Government and Investment-Grade Corporates or Municipal Bonds

For other types of bonds, whether you should pick your own or buy bond fund shares depends largely on how much money you have to invest in fixed-income. Richard Lehmann, president of the Miami-based Bond Investors Association, says that if you've got at least $50,000 to invest in fixed-income, you might be able to save some money by investing in individual securities.

Michael Joehnk, professor of finance at Arizona State University, puts that the figure even higher.

"I firmly believe that the bond market is not a place where individuals belong unless they have a five- or six-figure portfolio," he said. Five or six figures in bonds alone, that is.

There are two reasons why you need a lot of money before it makes sense for you to invest in individual bonds. Diversification is the first. With most bonds having a face value of either $1,000 or $5,000, the cost of diversifying among different issuers mounts quickly.

Transaction costs are the other reason. And we'll pick up there in the next piece.

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