How to Choose Bond Funds? It's Not as Easy as You Think.

Bond funds are still suffering from the effects of the downturn.

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As interest rates continue to rise, bond investors who had forgotten what it was like to manage the risks of rising interest rates learned these lessons last year. Bond prices have fallen by double-digit percentages since the Fed raised interest rates from 0.25 percent to 4.5%.

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A vital question is whether it's worth locking in the rate that the Fed is looking to peak at long term in bonds, if we consider the Fed has indicated that rates are close to peaking after the latest increase-to 4.75% to 5%. However, if you own bonds funds, that will not allow you to do so. However, if you purchase individual bonds, then you can do that.

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The risk of dilution from other shareholders in funds arises from the fact that they are pooled assets. In the case of a fund that has invested $100 million in newly issued bonds with 5% yields and if the manager of the fund had to put that money to work at, say, a 3% rate, then the fund's combined yield became 4. The income you were going to receive in the future has just been lost.

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I think yields could come down from here, as they have historically during times of financial stress when investors begin to flee to safety, especially if there is a recession and investors begin to flee to bonds to stay safe. This is something that Jordan Rummel, a wealth advisor at LVM Capital Management in Portage, Michigan says.

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As a bond buyer who also works with funds, Rummel prefers to purchase bonds individually for large accounts rather than using funds to buy bonds, so he can buy bonds at a minimum of $25,000 or $50,000 per bond, and preferably $100,000, if it isn't a Treasury bond, just so he gets the best price available. Moreover, he prefers to buy bonds in larger amounts because brokers charge a markup for buying bonds, and the smaller a transaction, the greater the markup. You can tell if you pay for a similar bond issue in a different size by comparing the yields on similar bond issues for different purchases. These charges are often hidden from investors, embedded in the price of the bond.

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Compared to corporate and municipal bonds, Treasury bonds are generally very liquid, easy to trade, and generally have a smaller broker markup than those of corporate and municipal securities. Some of Rummel's clients can benefit from combining smaller amounts in individual Treasuries with corporate bond funds. The U.S. government sells Treasury Bonds for a nominal amount of $1,000, with no markups added. The bonds could be sold before they mature by transferring them to a broker and selling them through them, but it would require a transfer to a broker in order for them to be sold.

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It is possible to solve the cash-flow problem of buying individual, “laddered” bonds with varying maturities in order to minimize cash-flow issues. You can buy bonds that have a maturity of one year if you need money within the next year, but you can also buy bonds that mature within two years, a five-year maturity, a ten-year maturity, etc. Also, this will be able to lock in rates at different points in the yield curve, which is of particular importance today because long-term bonds tend to yield less than the short-term ones, a phenomenon known as inversion. At USTreasuryYieldCurve.com, you can find in real time the yields on a variety of short-term and long-term Treasury bonds, as well as compare them to those traded on earlier dates.

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Lew Altfest of Altfest Personal Wealth Management in New York says that laddering individual bonds makes sense now, but that most bonds should not be laddered by investors themselves. He says, “It is really important that you have someone who is looking over things constantly with some expertise, but that is not a requirement for U.S. Treasury bonds.”

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As Altfest says, it is a difficult process to purchase individual mortgage bonds for clients, but he has done it before. Additionally, he has bought a number of municipal bonds, such as the 4% tax-free bonds of the New York City Transitional Finance Authority that will mature in 2036. Generally, he sees individual municipal bonds as better suited for investors who want to buy and hold them for an extended period. When selling a municipal bond, he says, there can be liquidity difficulties associated with the sale.

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For individual bond investors seeking a juicy yield, there are large opportunities available to them, but you have to make sure you are aware of the risk involved with doing so.