With bonds trouncing stocks for the first time in years, you suddenly have reasons to move money into an asset class that hasn't gotten much recent attention--or respect. But if you're about to make a sizable commitment to bonds, think twice before dialing your mutual-fund company. When it comes to high-quality bonds such as Treasuries and AAA-rated corporates, there's little aside from convenience a fund can give you that you can't get on your own. In fact, if you have $50,000 or more to invest and plan to buy and hold, picking your own bonds can be a cheaper, more profitable way to go. "Bond funds don't add as much value as people think," says Marilyn Cohen, author of The Bond Bible (New York Institute of Finance; $24).
According to a 1999 study by the Charles Schwab Center for Investment Research, an investor with $50,000 can build a diversfied portfolio of high-grade bonds for no more, and often less, money than a comparable low-cost fund (table). To buy and hold $50,000 in Treasuries costs 0.13% a year, including commissions and the higher prices paid for buying small lots. That compares to about 0.15% for a low-cost fund.
Do-it-yourself investing looks better when you consider the typical bond fund's expenses. Treasury funds pocket an average of 0.77% of assets each year. But since these funds rose an average of 5.6% in each of the past five years, investors can ill afford to part with any returns.
Another reason to go it alone is that pros have little edge when picking Treasury, AAA-rated corporate, and insured municipal bonds. Such bonds stand virtually no chance of defaulting, and trade frequently enough to give individuals price data to secure good deals. So, investors face only one risk--that rising interest rates will punish bond prices. Since the pros have proved no better than others at forecasting rates, it makes no sense to pay one to do so.
UP THE LADDER. If the direct route appeals to you, buy at least five high-quality bonds maturing at different times. One method is to put at least $10,000 each into 2-, 4-, 6-, 8- and 10-year bonds. When the two-year bonds mature, reinvest the proceeds in new 10-year bonds. This laddering reduces the risk of losses that result from rising interest rates--which punish short-term securities less than long-term ones.
Bond funds still have a place in many portfolios. If you can only part with a little money, funds are the best route. And if your idea is a short stay in bonds--say, to wait out the recent stock market turmoil--funds are the best solution because transaction costs can sink do-it-yourselfers who trade. To see why, consider a bond fund that sells $250,000 of Treasuries. While it faces commission and other transaction costs of about $39--or 0.0156% of its investment--an individual unloading $5,000 of Treasuries pays about $68, a hefty 1.37% of assets, according to Jim Peterson, a vice-president at Schwab.
Moreover, the pros can add value in some sectors. For example, with defaults on junk bonds rising and trading volumes falling, a fund can give you both expert credit analysis and the market muscle to get good prices. That said, why compensate a manager unnecessarily? What you give up in convenience, you'll gain in higher returns.