Last year was the second consecutive year of historic inflows into retail fixed-income mutual funds. By the end of 2010, retail investors held $1.23 trillion in actively managed fixed-income mutual funds ($819 billion taxable + $409 billion municipal) compared with $768 billion at the end of 2008 ($470 billion + $298 billion), according to the University of Chicago's Center for Research in Security Prices. That's a 60% increase in just two years.

Those are striking figures, but considering the extreme stock market losses of 2008, it's not surprising fixed income has become so popular. Investment-grade bond funds are typically less volatile than stock funds and are also easily accessible, particularly in 401(k) plans, so they've been a convenient option for investors hoping to reduce risk and put money to work quickly.

But as with any investment, they involve tradeoffs. In particular, actively managed mutual funds can be an expensive way to access the fixed-income market. And perhaps more important, bond funds are susceptible to interest rate risk, which means fund values fall when rates rise. So in a rising-rate environment, retail investors lose twice: from a fund's fees as well as the drop in its value.

Individual bonds, on the other hand, are subject to neither of these problems (as long as they are held to maturity and don't default). A new study by BondDesk Group suggests that buying individual bonds in the retail market (trade size under $100,000 par value) is among the most cost-effective ways to access the fixed-income market. And in a rising-rate environment, individual bonds will have a paper loss, but as long as they are held to maturity and there is no default, they will return their principal in full.



Although it's been hard to compare the transaction costs of individual bonds and bond funds, new research is making it easier. Here's a way to see what it costs individual investors to purchase each type of fixed-income product:

* Mutual funds. According to the Center for Research in Security Prices, in 2010, the weighted average expense ratio of retail taxable bond funds was 82 basis points. This means that last year retail investors spent more than $6.7 billion on fund expenses just for taxable bonds. The weighted average expense ratio for municipal bond funds was a little lower at 64 basis points, with investors paying another $2.6 billion in fees. That's $9.3 billion in 2010 alone.

Moreover, the fees are annual, so the money is diverted from investors' accounts each year and transferred to the fund management companies. Of course, fund companies need to charge their investors in order to cover operating expenses, which include a variety of valuable services such as portfolio management, credit review, reinvestment of dividends and reporting. But on a compounded basis, the fees can be a material drag on performance.

* Individual fixed-income securities. Fortunately, investors who want to include fixed income in their portfolios have a cost-effective alternative: They can build portfolios of individual fixed-income securities. Although it's considerably less popular than investing in mutual funds, it can be less expensive.

BondDesk's study estimated the retail transaction costs for corporate and municipal bonds in 2010, and found the median expense was 22 basis points of yield for a corporate bond and 23 basis points of yield for a municipal bond. This is significant because it establishes a baseline for comparing the costs of buying bonds to the costs of owning funds.

Transaction costs as a percent of yield are directly comparable to mutual fund expense ratios because both fees reduce return on an annual basis. Transaction costs in the bond market are mostly invisible, just as they are in any retail purchase.

Suppose you are buying a new pair of shoes. The price tag only tells you how much the shoes cost. It doesn't tell you how much the store marked them up over the price it paid to its wholesaler or how much the wholesaler marked them up over the manufacturer's price.

Buying a bond is similar. When you buy a bond, you usually pay the price the seller is asking. But you don't know exactly what the seller paid for the bond. Some brokers disclose their trading commissions, but that is only a portion of the overall transaction cost. The majority of the markup is the difference between the price they paid and the price you pay, which is not typically disclosed.

BondDesk has developed a reliable method for estimating the transaction costs of corporate and municipal bonds. The process is conceptually straightforward: We compare selling prices for retail buyers (bond trades under $100,000 par value) to an estimate of the value of the same bond on the same date based on selling prices for institutional buyers (bond trades topping $250,000 par value), and measure the difference.

We then convert the price difference into yield to express the costs on an annual basis. As cited earlier, the median costs last year for corporate and municipal bonds were 22 basis points and 23 basis points of yield, respectively. Bond fund proponents have argued that transaction costs for small purchases are expensive, but our study shows the reverse is true.



The other major problem with bond funds is that they are susceptible to interest rate risk. If rates rise, fund values will decrease (and vice versa). Depending on the type of fund, the loss could be quite substantial. For example, a long-term bond fund with a duration of 10 years would lose 10% if long-term rates increase a single point.

Individual bonds, on the other hand, can experience an unrealized loss during a rising-rate environment, but as long as they're held to maturity (and no defaults occur), the payoff is certain. That's why bonds are known as "fixed" income; they pay a fixed coupon during the holding period and a predetermined, contractually obligated amount at maturity.

Of course, nobody knows where rates will go, but there's clearly more downside risk than upside potential. Ben Bernanke and the Federal Reserve are trying to keep interest rates low with QE2, a $600 billion long-term Treasury-buying program. Nonetheless, the 10-year Treasury has increased a bit more than 1% since October.

Not surprisingly, bond fund values have suffered. According to Morningstar, 21 of 57 long-term bond funds have negative returns this year (as of April 12). This is a perfect case of the conundrum facing retail investors. Even professionally managed long-term bond funds drop in value when long-term rates rise. Of course, the fund companies continue to collect management fees, which means retail investors lose twice.



Bond funds play a critical role in retail portfolios, and they may be an essential option for older workers who contribute regularly to retirement plans. But they are certainly not without tradeoffs and risks, and it's important that financial advisors be aware of them.

Clients with the flexibility to supplement their portfolios with individual bonds should consider doing so. They establish a floor under the portfolio that can help minimize a loss of principal in a rising-rate environment, and they can be a cheaper way to access the market.

Bonds are also quite flexible. Retail brokers now have tens of thousands of unique issues available, meaning that investors can select bonds from most any industry, maturity or credit rating that suits their needs. And they are often available in increments of $5,000 to $10,000, so investors don't have to be wealthy to make the purchase.


Chris Shayne, CFA, is a senor market strategist at BondDesk Group, which operates a retail fixed-income electronic trading platform through its wholly owned subsidiary, BondDesk Trading.