Corporate Cold Calling: Companies Try to Lure Investors With Bonds

This time, it's the companies -- not the investors -- that are following the money.

In June, equity mutual funds recorded net outflows of $11.1 billion, while taxable bond funds saw inflows of $11.4 billion, according to AMG Data Services. And corporate America has duly noted this shift.

Anxious to raise capital by any means, companies have begun to issue bonds targeted at the retail investor. (Generally, bonds are sold first to institutional investors, then to individuals on the secondary market.) Meanwhile, the National Association of Securities Dealers just launched the first-ever bond-quoting Web site, enabling the public to track corporate bond trades.

Now it's easier than ever for retail investors to jump straight into corporate bonds. Sounds great, right? Not so fast. Buying bonds isn't as easy as picking stocks -- and we've learned the hard way how difficult good stock-picking can be. Further, individuals are often at a disadvantage when buying bonds on their own, rather than through a fund.

You're the Target

The appeal that companies are making to individual investors in marketing new bond issues has (surprise!) an ulterior motive. "Institutions aren't buying any bonds and keeping companies afloat," says RealMoney Pro's Brian Reynolds, formerly a fixed-income portfolio manager and economist at David L. Babson & Co. "This kind of tactic -- targeting individuals -- can be great for companies."

This new breed of corporate bond, issued by the likes of IBM ( IBM), United Parcel Service ( UPS) and Boeing ( BA), is designed to appeal to individuals in a few ways. For starters, many of them pay interest monthly, an attractive feature for those who are looking for a steady and predictable income. Bond funds sometimes have irregular payouts.

The bonds are generally medium-term notes with durations of two to 10 years -- which means investors incur less interest-rate risk and get the bond's par value back soon. And they're sold in small blocks -- for instance, investors can purchase IBM's five-year note in $1,000 increments. These bonds can be purchased through online, discount and traditional brokerages.

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Litany of Caveats

But the list of negatives is much longer.

First, information is tougher to come by. Information that backs a company's creditworthiness isn't as accessible as that from the multitude of sources that provide stock data. And that's not just a concern for high-yield issues. Four of the biggest corporate-debt issuers -- Enron, WorldCom, Qwest and Tyco -- were once considered investment grade.

Protecting yourself from blowups through diversification can be costly for individuals. Some 30 to 40 names are required to establish a diversified portfolio. Currently, just 17 companies have issued bonds directly to retail investors. That means investors would have to supplement their bond holdings with others bought on the secondary market.

Which brings us to the all-important pricing issue. "If all bonds traded at par value with the same maturity, you'd know what you're getting," says Bill Fuhs, managing director of Fleet's private clients group. "But bonds never trade that way." When bonds are sold in the secondary market, they trade at either a discount or a premium to their par value. In effect, the premium/discount fluctuates much the same way a stock price would, given either company or market news.

In the case of these new bonds, though, the secondary market is quite small, and investors interested in selling their bonds before maturity will likely be forced to sell at a discount.

Individuals always get short shrift in the secondary market, Reynolds says. "The joke in the institutional market when a dealer gives you a lousy bid is to say 'What is that, a retail bid?'" he says. And the NASD's new Web site serves only to highlight the issue, rather than correct it.

The NASD quoting system provides data on 500 bonds, primarily big, liquid issues. But a quick test of the system reveals the discrepancy between what individuals pay (identified by the smaller lots purchased) vs. the institutions. "Those off-market prices are retail investors getting abused," Reynolds says.

Weighing Economies of Scale

Since the retail investor represents such a tiny slice of the bond market, companies have little incentive to offer many bargains, even when trying to woo the individiual investor. Boeing, for instance, sold $7.8 million in 10-year bonds that paid 5.6% to retail investors. Less than a week later, though, it issued $600 million in to institutional customers. That lot of 11-year bonds paid 5.8% -- a better yield for the institutional buyers.

And let's not forget about trading costs and transaction fees, which can slice into returns -- far more so than a bond fund's expense ratio would. Let's say you buy a $1,000 lot of IBM's five-year note, yielding 4.2%. If you buy that through an online broker that charges $40 per transaction, you've essentially lost a year's worth of interest ($42, in this case) just to cover your transaction cost. "Bond trading is all about economies of scale," Reynolds says. "In almost all instances investors are better off in funds."

Even portfolio managers who use individual bonds to provide regular income for clients do so in a way that almost mimics the scale of a mutual fund. "Most of our clients have at least $250,000 in individual bonds," says Stewart Welch III, a financial planner in Birmingham, Ala. "We usually buy corporate bonds in blocks of $50,000; we wouldn't buy bonds in blocks of less than $25,000."

Investors looking to put less than $200,000 would almost always do better from a diversification and cost standpoint in mutual funds.

"There are some excellent bond funds," Fuhs says. "And although you'll pay a fee, the bonds go into the fund at wholesale prices." Ultimately, it's your total return that matters. And the best way for most investors to ensure a solid return from a well-diversified and efficiently managed bond portfolio is to do so through a fund.

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