Don't Let Your Bond Fund Bite You

If you want to protect some of your money from the vicissitudes of the stock market, the natural choice is bonds.

The easiest way to purchase a well-diversified portfolio of bonds is through a low-cost bond mutual fund or exchange-traded fund (ETF). These funds have hundreds of holdings, so if one issuer goes under, investors won't see a significant loss, and it's easy to invest as little as $100 at a time into a bond fund (though you may pay a commission if you're investing in an ETF).

But because bond funds are made up of so many moving parts -- hundreds of holdings with different maturities constantly being bought and sold -- investors can never be sure exactly how much their investment will be at any given time, or how much income they'll receive. This is a particular concern for investors counting on their bond investments to return a specific amount of money on a specific date, such as retirees investing in bonds for income.

Check out the highs and lows of these bond funds over the past five years, and you'll see how volatile bond funds can be:

Source: Yahoo! Finance.

The solution for such investors is to buy individual bonds. That's right -- surveying a broker's bond lineup and deciding whether to buy one company's 7% bond maturing in 2014 or another's 6% bond that matures in 2013.

By buying individual bonds, you know exactly how much you'll get back when the bond matures, regardless of what happens to the economy, the bond market, or interest rates. Assuming, of course, the bond issuer is still in business.

If that sounds intriguing to you, here are seven tips to help you make sure you get the most bang for your bond bucks.

1. Invest enough to be diversified. Don't attempt to construct your own bond portfolio unless you have at least $50,000 to invest in bonds; $100,000 is better. Corporations, municipalities (cities, counties, and states), and foreign governments can and do go bankrupt and default on their debt. That doesn't necessarily mean you would lose everything you'd invested in a bankrupt issuer, but you wouldn't get your money back for a while, and it probably wouldn't be as much as you invested. So spread your bond money around.

2. Stick to investment-grade bonds. To minimize the risk of buying bonds from a company that goes belly up, stick with investment-grade issuers -- those rated BBB or higher by Standard & Poor's or Baa or higher by Moody's. Of course, a better rating -- one that starts with an A -- is even safer. According to a study by Moody's, from 1970 to 2006, the cumulative default of Baa-rated corporate bonds was 4.6%, whereas B-rated corporate bonds (aka junk bonds) had a cumulative default rate of 43.3%. (Yes, the ratings agencies have totally disgraced and discredited themselves by slapping AAA ratings on subprime mortgages, but they're still the only game in town, and the processes for rating corporate and government debt aren't quite as corrupt.)

Important note: Ratings for corporate bonds and municipal bonds are on different scales. Again according to Moody's, A-rated munis had a cumulative default rate of 0.03%, compared with 1.3% for A-rated corporates. So as you determine which bonds to buy, make sure you're properly comparing A's to A's.

3. Know the true costs. One of the tricky aspects of buying individual bonds is knowing how much you're paying for them. Sure, you'll know the commission up front. But the broker will also add a markup to the bond, which probably won't be revealed. Make sure you ask your broker what the after-cost yield of the bond will be before you buy.

4. Find out whether the bond can be called. Every bond has a set maturity date, but many can also be "called" before then. That happens when a company decides to pay off its bondholders before maturity, usually because interest rates have dropped, or the bonds' credit rating has improved, allowing the issuer to redeem old bonds and issue new ones at lower rates. Investors are left having to reinvest their money at lower rates. Make sure you know beforehand whether the bond you're about to purchase is callable, and, if so, what the "yield-to-call" -- how much you'd earn from the investment -- is if that happens.

5. See if you're getting a good deal. MSRB.org and InvestingInBonds.com have the trade history, yield, price, and ratings of thousands of bonds. Stack that data up against what your broker is offering to see if you're getting skinned.

6. Pursue the primary market. When bonds are first sold to investors -- on what is known as the primary market -- they are usually sold in $1,000 increments, and the issuer often doesn't charge a commission or markup. After a bond is issued, it trades on an exchange, known as the secondary market. At that point, a bond rarely trades for $1,000; the price will be higher or lower, depending on changes in interest rates and the issuer's financial stability. This adds a layer of tax complexity to the bond because when it matures for $1,000, investors will either realize a capital loss or gain.

Getting bonds on the primary market isn't easy. You'll increase your chances by having an account with a brokerage that underwrites a lot of bond offerings, such as brokerages that also offer investment banking. Some of the bigger discount brokers, such as Zions Direct, also have access to some primary offerings.

7. Buy directly from Uncle Sam. You can buy savings bonds, Treasuries, I bonds, and Treasury Inflation-Protected Securities directly from the government, commission-free, at TreasuryDirect.gov. This can only be done in taxable accounts, though, as the government isn't set up to serve as a custodian for IRAs.

Which is best for you?
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