"You don't have good control over the mark-up, costs and expenses involved," Brennan says. "Bonds [require] a special expertise beyond what you may even need to be a stock picker. You know what the price is for a stock. For bonds, you really don't know. If somebody is getting an extra 20, 30 or 40 basis points, that can be an awful lot of money. I've got to think we're better off using managers."
Brennan figures that with a bond fund, you not only start out with lower expenses, but a good fund manager can pick up another 25 basis points in total return. He admits that he has shifted gears recently due to the fact that rising rates trigger a major problem with bond funds.
When interest rates rise, the value of a bond fund falls. "You're never guaranteed that you'll get your initial investment back," he says. "A bond fund can go up and down, and theoretically never come up again. With an individual bond, you know it's going to mature at face value."
Of his $130 million under management, Brennan figured in May that he had 30% in bonds. In early 2004, he estimates 70% of that bond portfolio was in bond mutual funds and 30% in original issue bonds. More recently, he had swung the other way, keeping 70% of his bond portfolio largely in original-issue agency bonds and CDs due to the expectation of rising interest rates. "I've shortened the terms down significantly. I buy step bonds in initial offering, which are callable at par-somewhere in the area of three, four or five years."
Konstantine "Dino" Mallas, T. Rowe Price fund manager for municipal bond funds, notes that buy-and-hold municipal bond investors needn't fear the price swings of bond funds. But if financial advisors prefer to trade for clients on the secondary market, they need to do their homework to track prices.
Particularly with rising rates, Mallas says, anyone trading municipal bonds also needs to consider the "de minimis" tax rule. If the bond trades below a certain price level, the investor risks owing ordinary income tax-rather than capital gains tax-on the price appreciation.
"Avoid bonds with low original yields," he says. "Look for a higher yield comparable to where yields are today." At this writing, municipal bonds were being issued at 5.15% to 5.20% in the primary market. Also, Mallas advised, go for higher coupons as opposed to lower coupons. "A premium bond is more likely to protect you from having a bond going outside of the de minimis, where it suffers an additional penalty if you go to sell it."