Isn't Buying a Mutual Fund Easier Than Creating a Bond Ladder?

You might be better off owning bonds directly, depending on your circumstances.
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I think that I understand the bond ladder philosophy, but why can't I spread it evenly over bond mutual funds -- say, Vanguard bond funds -- having different average lengths and forget about reinvesting every year? I can get low expenses, diversity and liquidity. Can you think of reasons not to do this approach to retirement sanity? -- Arnie Rabinowitz

Arnie,

Glad you understand how the bond ladder works; readers who don't can see a previous

Fund Forum for a explanation.

The strategy you propose certainly has its merits, and you named them -- low expenses (in the case of

Vanguard's

funds), diversity and liquidity.

Even so, depending on what type of bonds you want to buy, your goals and how much money you have, it may not be the best strategy for you.

I can think of four reasons why you might not want to pursue this strategy.

Bonds may be better suited to your goals than funds. The best argument against bond funds is that they don't offer the very things that investors buy bonds for. A bond is a promise to make fixed interest payments according to a schedule and to repay principal upon maturity. A bond fund promises neither of those things. Its dividend may fluctuate, and its principal may not be worth as much when the investor wants it back. If you are buying fixed income in part because you know you are going to need money for a specific purpose at certain times, it may be better to buy bonds that will mature on or around those dates.

You may want only Treasury bonds. If you want only Treasury bonds, its hard to beat

Treasury Direct on the cost front, even if you're Vanguard. The program lets you buy Treasury securities directly from the Treasury at auction. The only expense is a $25 annual fee on accounts over $100,000. That's 0.025% or less. The only reasons you might want to buy a Treasury fund instead are if you really need the liquidity (although Treasury Direct will solicit bids and sell your security to the highest bidder for a $34 fee) or if you want automatic reinvestment of dividends. You can't automatically reinvest the income that bonds held in Treasury Direct will throw off, but you can automatically reinvest fund dividends.

You may have enough money so that it makes more sense to buy municipal bonds directly. (If you have enough money, it's very likely you'll do better in munis than in taxable bonds.) With Treasuries, just about anyone can save on expenses by going through Treasury Direct. But with other types of bonds, which you have to buy from a broker, you may do better in a fund unless you're investing enough that you can buy at a good price. With bonds, the yield you get on a purchase depends a lot on how many you're buying at a time. How much do you have to spend to get a good price? "You really need at least $1 million," says Jim Cusser, manager of

Waddell & Reed's

United Bond Fund. That's $1 million per bond. Assuming you don't want to sink your whole nest egg into one bond, Cusser says, "you need at least $10 million to pull it off." Dan Peirce, a bond specialist at

BancBoston Robertson Stephens

adds: "Even if you have a lot of money, it's difficult to get good prices on your own."

You might be able to take more risk than a fund can. Funds, Cusser explains, aim to consistently top the performance charts. To do that, they may pursue strategies that are less risky -- but ultimately less profitable -- than an individual investor could afford to take on his or her own. "No matter what fund you buy, whether it's short, intermediate or long term," Cusser says, "the investment manager has a limited time horizon, which may or may not jibe with the time horizon of the investor." It gets back to the first question: What's the goal? If the goal is to have $50,000 come due each year for four years starting in18 years to pay for the college education of someone who's currently an infant, an investor should think about buying zero-coupon bonds. Yes, they are the most interest-rate-sensitive bonds you can buy, and few funds would load up on them for that reason. But if they suit your purpose and you're sure you won't need to sell before maturity, who cares?

I am intending to build a bond ladder of California municipal bonds not subject to the AMT. I will be investing approximately $8 million. How many steps should the ladder contain? I am assuming an equal dollar distribution among the various steps. -- Mel S. Goldsmith

Mel,

I talked to David MacEwen, who manages just such a portfolio for

American Century

. (The firm's California funds, except for the high-yield fund, don't hold bonds subject to the alternative minimum tax. For more on the AMT, see our recent

primer on the subject.)

He says you shouldn't have any trouble restricting your portfolio to non-AMT-subject bonds since the majority of California issuance is non-AMT. (Last year, just $2.1 billion, or 6.2%, of the $33.9 billion of new issues in California was subject to the AMT, according to

Securities Data

.)

MacEwen has six points of advice.

Don't be hasty. "There hasn't been much issuance of Cal paper lately," he says. "We're seeing lots of demand from

big brokerages who want to buy our bonds and sell them to retail, so we know there's a scarcity of paper out there. So he's going to have to be patient. I would think it could take as long as a month" to invest $8 million wisely, MacEwen says.

Stick with insured bonds. "Spreads are tight. You're not really being compensated to buy anything but insured bonds," the manager says. There's good value in some high-yield issues, but you should assume that anything a dealer shows a retail investor has been rejected by an institution that employs a staff of analysts to spot problem bonds.

Figure on buying blocks of bonds no smaller than $400,000 in order to get them at a decent price. You don't need to spend more than $1 million per block to get good pricing. MacEwen thinks an $8 million ladder portfolio should have 10 to 15 positions.

When you go to buy, ask your broker to show you scales for recent pricings. If you're thinking about buying an insured bond due in 2013, you want to know what yield investors recently got on a similar bond.

Consider setting up something a little different from a conventional ladder. MacEwen says the California yield curve has a nice positive slope out to 20 years, meaning that yields on bonds due in 15 to 20 years are high relative to short-term yields. "He might want to consider pushing out to the 20-year area to capture some of the yield there," he says. That doesn't mean you have to have a 20-step ladder, which is going to give you a longer average maturity than you might want. Instead, think about building a five- to 10-year ladder with two-thirds of the portfolio and sinking the final third into the 15- to 20-year area. How you manage the portfolio over time depends on whether the yield curve continues to reward you for tying up your money for up to 20 years.

Look out for calls! Most muni bonds are callable 10 years after they're issued. You shouldn't necessarily avoid calls, since noncallable bonds are very expensive. But don't let yourself be blindsided by them.

Thanks to everyone who sent a question in response to last week's plea. The response was overwhelming. Unfortunately, that means some questions are going to have to wait a while for answers. Please be patient. I'll tackle them in order of how time-sensitive they seem to me to be. (This week's first question was in my mailbox before the plea went out.)

Please continue sending your stock fund or bond fund questions to

fundforum@thestreet.com and remember to include your full name.

TSC Fund Forum aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.