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By yodaorange
February 4, 2010

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Missah wrote: "I would never buy a bond fund and I suspect, without a shred of evidence, that the small individual investor gets ... on the spread when buying an existing bond."

Missah, a few comments on buying individual bonds. As I mentioned in an earlier post, we have 300+ different issues of bonds in the portfolios I manage, so hopefully I have learned a few things.

1) An individual can buy Corporate/Muni/CD bonds pretty easily these days. All of the large discount brokerages Fidelity/Schwab/Waterhouse offer them as "Over the Counter" offerings. The inventory available is changing in real time. What you see one minute might not be offered the next minute. You have to understand these are very different from listed stocks, in that some of these issues will literally go years without a single trade.

2) The buying of these issues is pretty efficient and cost effective. One of the big things that has helped is that you can generally get a calculated "fair value" plus see the trading history of the bond before you but it. In the old days, the dealers had all of the information and you were at a major disadvantage. These days, you can at least see the information in advance.

3) You can typically buy bonds at or slightly below their "fair value" as calculated by a third party. So if you plan to hold them until maturity you are set. You know exactly what your costs and yield are going to be.

4) If you decide to or have to sell them early, you might be in trouble. Unlike stocks that have either a market maker or a specialist assinged, bonds do NOT. So there is NO buyer of last resort. I have not had this happen to me, but it is possible that NO buyers will raise their hand when you want to sell. If you own GE or something comparable, I would not worry about a lack of buyers. If you own something obscure and the bond market it jittery, you might be in trouble.

5) All of our bonds mature in 5 years or less. That is by design as opposed to an accident. Every bond is bought with the intention of holding it to maturity. I have sold very few bonds in the last few years. Recently, I did sell a Chicago O'hare Airport bond due to concerns about Illinois budget troubles. It was a large number of bonds. In this case, I sold them for about 2% less than the "fair value" price. Luckily I bought them at a good price, so still had a capital gain. But this is a very high and painful bid/ask spread. You should NOT plan on selling bonds, because after a while 2% becomes a obstacle to good returns. Contrast this to a typcial bid/ask spread on REIT preferreds of ~ .6%.

6) There is a minimum commission and a maximum commission for each trade. If the minimum commission is say $8 and you buy 1 bond, you just spent .8% commision for that bond. So that would tend to have you buying 8 or more bonds at a minimum. Many of the bond offerings have minimum purchase quantities. I have seen these anywhere from ~5 to 150 bonds, each at ~ $1,000 per bond.

7) I am 98% comfortable with anybody buying FDIC insured CD's on the secondary market. The 2% discomfort is if they ever let FDIC fail.

8) I am 51% comfortable buying Fannie, Freddie, TVA etc government backed bonds. I agree with Jim that there is always some percent chance a future administration will choose to not support them. We should have let Fannie and Freddie FAIL but that is for a different post. . .

9) Muni bond are all over the place IMO. I would NOT buy any California or Michigan bond of any kind guaranteed by anything. It just varies by city, state as to whether you thing the credit risk is acceptable. The city of Vallejo, California literally went bankrupt in 2008, so caveat emptor. Some of us might remember WHOOPS bonds from 1983 that defaulted.

10) Coporate bonds are also all over the place IMO. You could be an unfortunate soul that thought you had a safe lifetime investment in GM bonds only to be wiped out.

11) For our accounts, I will NOT buy any bonds that mature in >5 years. VNOD,WRE and HRPN are exceptions. These all mature in either 10 or 30 years. I would own them solely because I hope I could easily sell them for a small bid/ask spread, as opposed to the OTC bonds with the 2% plus spreads. IMO we will have increased inflation sometime in the next 30 years, so I am unwilling to commit to holding 30 year bonds to maturity.

Probably a little more info than you asked for. . .