How to Buy Bonds

The major types of fixed-income securities include:

    US government bonds,
    federal agency bonds,
    foreign government bonds,
    municipal bonds,
    corporate bonds,
    and mortgage or asset-backed securities.

You can invest in bonds by buying them individually, or by purchasing shares in a unit investment trust or bond fund. Individual Bonds One approach is to buy individual bonds from a securities broker or dealer. Bond prices typically include a dealer's markup, which is similar to the commission paid on a stock trade.

US Treasury securities, including T-bills, notes, and bonds, can be purchased directly from the federal government at a Treasury auction. (Please see www.publicdebt.treas.gov for details.) They can also be bought through a Federal Reserve Bank, financial institution, or government securities dealer.

US Savings Bonds can be purchased directly from the government on the web at www.publicdebt.treas.gov/ols/olshome.htm.
The minimum purchase price for a Treasury security is $1,000.

Corporate bonds are usually sold in $5,000 denominations, but dealers sometimes require a minimum investment of $20,000 for a single bond. As a result, most individual investors have a hard time achieving adequate diversification with individual bonds.

Bond Unit Investment Trusts Unit investment trusts (UITs) consist of a basket of securities that remains constant throughout the life of the trust. Bond UITs typically focus on one segment of the bond market, such as government, municipal, mortgage-backed or corporate bonds. The advantage of a UIT is that you know exactly how much you will earn, because the composition of the portfolio is fixed. You receive interest payments throughout the life of the trust and recover your principal as individual bonds are redeemed. The trust typically ends when the last security matures.

Bond Mutual Funds for small investors, bond mutual funds are the preferred method for investing in fixed-income securities. The great advantage of bond funds is that they provide instant diversification. However, it may require several funds to diversify across all the major bond categories. As with stocks, bond portfolios can be managed actively or passively.

Active management implies that the portfolio manager is attempting to outperform the market averages by selecting superior securities. In a passively-managed portfolio, the goal is merely to match the returns of a particular bond index. We recommend passively-managed bond funds (or index funds) because they tend to provide higher net returns over the long run than actively-managed funds with similar risk levels.

Index bond funds have lower management fees and lower transaction costs than actively-managed funds. These lower costs are durable and predictable, while the benefits of active management are unpredictable and inconsistent. Our preferred provider of bond index funds is Dimensional Fund Advisors (DFA), which was recently rated as the best overall mutual fund company in a survey of 1,100 professional investment managers ("The Professionals' Pick" -Dalbar Research).

Next month, we'll discuss inflation-indexed bonds.

February 1, 2002

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