Investing in individual bonds may not be appropriate for the average investor.

That was the sentiment expressed by Charles Schwab, the nation's No. 1 discount brokerage, in a recent research note. The report weighed the merits of both individual fixed-income securities and fixed-income mutual funds to help individuals make a sound investment decision. "With the current upheaval in bonds, there are a lot of distractions in the marketplace that make it difficult to determine which fixed-income investment best fits an individual portfolio," wrote Dr. James Peterson, vice president of the Schwab Center of Investment Research.

San Francisco-based Schwab's key finding, however, was that individuals with less than $50,000 to invest are more suited for a bond mutual fund than individual securities. A diversified portfolio of corporate bonds would require a minimum investment of $50,000, while a well-diversified municipal bond portfolio would require at least $100,000, Peterson said. To achieve default-risk diversification, each type of basket should hold bonds from at least 10 different issuers, he said.

Bond funds offer diversification with a relatively small amount of money and access to professional management, credit oversight and the ability to reinvest back into the fund. They also tend to be easier to monitor and more readily liquidated than bonds that are traded less frequently, according to Schwab. With an individual bond, an investor knows exactly how much income that bond will pay over its lifespan, and the principal is guaranteed.

While Schwab did not blatantly advocate buying mutual funds over individual bonds, the firm is hoping to attract customers by breaking down the comparative costs. For example, an investor pays commissions or mark-ups on each trade, whereas at Schwab investors can select funds without a sales load. Essentially, it doesn't make economic sense to buy or sell a bond in increments less than $5,000 for government and corporate issues and $10,000 for munis. Schwab doesn't charge a liquidation fee if a bond fund is held more than 180 days. In the case of individual bonds, there may be markdowns if they are sold prior to maturity.

"I'm not quite sure what Schwab is thinking, but frankly they're not a huge player in the bond world and they probably do most of their fixed-income business through mutual funds," said Bill Hornbarger, chief fixed-income strategist at A.G. Edwards of St. Louis. "If I'm interested in insured, intermediate-term, triple-rated municipal bonds and I plan on holding them until maturity, I can get four or five different issues for as little as $25,000. So I'm not really sure that $50,000 to $100,000 washes."

However, an individual seeking adequate exposure to high-yield bonds can't buy enough individual issues to get diversification, even with a $200,000 account, he said. In that instance, a bond fund makes sense. And for investors looking for price transparency, Hornbarger would advise putting cash into exchange-traded bond funds.

"If one has at least $100,000 or more to invest, [one] can create their own personal bond fund to fit [one's own] risk and investment parameters instead of investing in a mutual bond fund," said Doug Geisser, vice president at Romano Brothers & Co., an investment firm in Evanston, Ill.

Geisser believes that there are a number of advantages to owning individual securities including the ability to ladder the maturities. If interest ratesmove higher in the future, one would be able to take advantage of it by having the new dollars to invest. Also, the annual management fees charged within a bond fund can be as high as 1%, taking a huge bite out of returns.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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