Exercise caution when investing in bonds


Caution needs to be exercised when investing in bonds, as many investors are under the misunderstanding that bonds cannot lose principal value.

Key Points

Q I'm retiring at the end of this year and am thinking about buying bonds since they seem more conservative than stocks. Are bonds safe, and what is the best method of investing in them?

From the moment a bond is purchased, it is subject to market fluctuation. This fluctuation is often attributable to overall changes in interest rates. As a general rule, bonds move inversely with interest rates. If interest rates go higher, bond prices decrease, and conversely, they go up in value as interest rates decrease.

Once you decide to add bonds to a portfolio, you must also determine how to structure the implementation. Bonds can be purchased on an individual basis, within a unit investment trust (UIT) or through a mutual fund. Constructing a portfolio of individual bonds offers more direct control over maturity, face value, bond type, credit range, and other bond characteristics. While this approach may be useful for matching future liabilities and pursuing other investment objectives, achieving broad diversification with a custom portfolio may prove a challenge. The portfolio may be less liquid, more expensive to trade, and require a higher degree of oversight than is feasible for the average investor.

In order to provide greater diversification and reduce the impact of individual defaults, many firms offer UITs. The portfolio manager assembles a variety of bonds with similar maturities that can be categorized as short-, intermediate-, or long-term to form a UIT. Most UITs purchase bonds from 20 to 30 issuers, allowing the investor to spread his risk by buying a piece of all the bonds within the portfolio. As the individual bonds within the trust mature, the proceeds are paid to the investor.

As an alternative to UITs, investors looking for additional bond diversification can buy shares in a mutual fund, which may have hundreds or even thousands of different bond issues. Since bonds are traded through a network of dealers and not a centralized exchange, bond funds have better access to multiple dealers than most individual investors. They also have the capacity for large-volume trades, which provides a cost advantage over smaller investors, particularly when trying to buy more bonds to increase diversification.

Funds tend to offer better liquidity and broader diversification across issue type, maturity, credit quality, and geography, although shareholders do not control the selection of bonds in the portfolio.

Shareholders can also access daily fund prices and know the average credit rating within the portfolio. Equally important, the fund managers are expected to monitor average yields at different maturities, qualities, and regions to gauge the relative riskiness of different issues.

Keep in mind that when investing in a bond mutual fund, you are never guaranteed the repayment of your principal, even when bonds mature. From a liquidity standpoint, bond mutual fund shares can be sold at any time, at the value at the time, which may be more or less than your original investment.

Q Due to unforeseen circumstances, I did not file my 2010 taxes. What is the penalty?

A The penalty for filing late is usually 5% of the unpaid taxes for each month (or partial month) that the return is late but cannot exceed 25% of your unpaid taxes. You will not have to pay a failure-to-file or failure-to-pay penalty if you can prove that you failed to file or pay on time because of reasonable cause and not because of deliberate neglect. At this point, it is best to consult an accountant for advice relative to your specific situation.

Joel M. Blau, CFP, (top) is president and Ronald J. Paprocki, JD, CFP, CHBC, is chief executive officer of MEDIQUS Asset Advisors, Inc. in Chicago. They can be reached at 800-883-8555 or blau@mediqus.com
or paprocki@mediqus.com

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