Navigate Past Bond Investing Stereotypes

Physician's Money Digest, August31 2004, Volume 11, Issue 16

Many physicians have to invest in bonds,but feel uneasy about it. They think thatbonds are complex. However, comparedto stocks, it is much easier to learn how toinvest in bonds. Here are five rules you can follow tobecome a better and more confident bond investor:

Safety drawback:

• Buy only high-quality bonds. One safety measureof a bond is its credit quality. The higher the quality ofa bond, the lower the chances of losing money. Youcannot assess the quality of a bond on your own. Sorely on the credit ratings of bonds, which are assignedby several independent bond rating agencies, and buyonly bonds rated A or higher. Incidentally, US Treasurybonds have a zero default risk. Because of this zero risk,however, they pay lower returns than bonds of otherissuers. Most of the time you're betteroff grabbing the extra return by buying high-qualitybonds from other issuers.

• Keep maturity short. Hold only short-maturitybonds (ie, bonds with a remaining life of around 5years). Why? Because when interest rates rise, bondprices fall. This is called a bond's interest rate risk,which increases with the maturity of a bond. If youhold long-maturity bonds and interest rates go upsharply, you may lose a lot of money.

Bond maturity in the range of 3 to 5 years usuallyprovides the best risk-return trade off. You will probablyearn 1% to 2% higher interest compared withmoney market funds or very short-term bonds withouttaking on too much risk. However, when interest ratesare poised to rise, you may want to keep the maturityof most of your bonds very short.

• Diversify your bond portfolio. Unless you areholding only Treasuries, you must broadly diversifyyour bond portfolio. In other words, hold bonds froma number of issuers in different industries to cushionpossible loss from the default of one or more bonds.High-quality bonds rarely default, but even they are notentirely immune to disaster.

Unless you have a large bond portfolio (eg, at least$500,000) and are knowledgeable about bonds, creatingand maintaining a properly diversified bond portfolio onyour own may be difficult and costly. But you can getinstant diversification for even a small bond portfolio byholding good bond funds instead of individual bonds.

• Watch your costs. Because bond returns are generallylower than stock returns, it is even more importantfor you to watch your costs. When you buy a new bondat the time it is issued, you do not pay any transactioncost. On all other bonds, you pay a transaction cost,often a hefty one. The transaction cost is generally builtinto the purchasing price of the bond.

Brokers rarely quote the transaction cost for bondsseparately. They know that if you find out the size ofthe transaction cost, you will revolt. The truth is, it'sdifficult—if not impossible—for individual investors toget a good deal on individual bonds, especially in smalltransactions. Compare bonds and bond funds beforedeciding which is better for you.

• Hold bond funds instead of bonds. The good thingabout buying a well-managed bond fund is that you canget instant diversification at a low cost. But the vastmajority of bond funds have unjustifiably high costsand are poorly managed. Remember: If you buy anindividual bond and hold it to maturity, you will paythe transaction cost only once.

If you buy a bond fund, you will pay managementand other fees year after year. So look for well-managedbond funds with expense ratios less than 0.5%, preferablyaround 0.25%. Although these low fees will addup, a good bond fund is a better choice for mostinvestors. Always keep in mind that the bond part is thefoundation of your portfolio and should be safe.

Chandan Sengupta, author of The Only ProvenRoad to Investment Success (John Wiley; 2001)and Financial Modeling Using Excel and VBA(John Wiley; 2004), currently teaches finance atthe Fordham University Graduate School ofBusiness and consults with individuals on financialplanning and investment management. He welcomesquestions or comments at