9

To avoid the fees on bond mutual funds or exchange traded funds I have been thinking of buying actual bonds inside of my retirement portfolio. Does that make sense or are there drawbacks to consider?

12

I don't like buying individual bonds for my own portfolio. I actually used to buy long-term government strip bonds (Canadas or provincial bonds) but I stopped. Here are some reasons why:

  1. My broker allows me to purchase bonds via their web application. However, to sell a bond, I had to call in to the fixed-income trading desk. That was inconvenient. (But your broker may be different.)

  2. Bonds don't typically trade on a formal exchange. So, there's no cheap & easy way (as far as I know) to get an independent quote for a bond's value – I had to trust what my broker said my bond was worth when assessing my portfolio performance.

    I asked my broker once how they arrive at the "market value" shown – i.e. whether it was last bid, ask, or actual trade – and I was told they use a third party bond quotation / valuation information provider for the data, and that quotes are an estimate of what the bond would be worth, based on similar bonds. I quickly learned that wasn't the value I could actually get when selling it:

  3. When you're dealing with your broker to buy and sell bonds, you're likely dealing with theirs or a related investment bank which makes a market for specific issues of bonds. While I wasn't being charged an explicit commission to buy or sell bonds, it was evident the broker makes money off the spread: That is, the difference between what they would be willing to sell a bond for and what they would be willing to buy that same bond for. They will buy your bond back from you cheaper than what they could turn around and sell it to somebody else for. That's why they don't charge an explicit commission... it's built in and hidden!

Anyway, when I finally discovered my broker would seldom actually offer me the "market value" quoted for my bonds (typically, it would be bought back for a few percent less than it were theoretically worth), I gave up. I don't think bonds simply are liquid enough, nor the costs transparent enough for retail investors. (Or maybe it's just me :-)

However, I do think bonds remain an important part of a diversified portfolio:

Bonds ought to be represented in a diversified portfolio using low-cost bond index mutual funds or exchange-traded funds. Since these funds buy & sell bonds in large quantities, they get a better deal on the spreads. So, while you do pay an explicit management fee for a fund, you are probably saving since you're not getting shafted on the spreads.

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  • 5
    If you have a specific date to spend your money, a bond fund has a different interest rate risk profile: If you have a 10 year bond and interest rates spike 1% with half a year to maturity, the face value drops about 0.5% but you'll still get your money at the end. If you have a bond fund with a 10-year average maturity, you'll lose over 10% (due to compounding) if interest rates rise, and be about 10 years away from making it up in interest, no matter how close you are to spending the money. – user296 Sep 8 '10 at 5:09
3

Avoiding fees would not be the primary reason to buy bonds yourself. No, the reason to buy bonds yourself in a retirement account is that you can hold them to maturity. Bond funds can and do lose value if interest rates rise (and gain it if interest rates fall). Of course the same happens with the bond that you hold, but you can hang on to it until maturity and get the face value out of it.

That said, it would take some effort to put together a decent bond portfolio, especially if you were going to buy anything rated lower than the absolute best. I think it'd be fun to do, but I'm weird that way.

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You need to have a lot of money to play with direct bond investing safely. Trading bonds is not for amateurs, and the layman-friendly publications don't provide a lot of guidance. Unless you're prepared to hold a bond to maturity, the prices of even high quality bonds swing wildly.

If you need a source of income, but not necessarily the ability to make money trading the bonds, look at Savings Bonds (specifically I-Bonds). 

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  • um.. savings bonds like I-bonds don't send you the income, it gets added to the value of the bond. You don't get your money until you redeem it. – Patches Jan 3 '12 at 17:29

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