Invest in fixed income securities only through low cost bond market index funds
Bond trading is a very complex process that individual investors should leave to professional fund managers. The pricing and trading of bonds and fixed income securities is far more convoluted than for common stocks or equities. Furthermore, bond pricing is much less transparent and has wide spreads. In a very real sense, you buy at retail prices and sell at wholesale prices.
Securities pricing in the bond market is much different from the stock market. While a firm usually has only one kind of common stock, it could have dozens or even hundreds of different outstanding fixed income securities. Few individual investors have the required skill, knowledge, information, and experience to assess bond market prices.
Fixed income securities or bonds have different valuation characteristics than do common stock securities, and bonds require different valuation methods. Common stock investments give the investor a claim to part of the market value of the firm and to its dividends, if the Board of Directors declares any such payments.
Compared to common stock held by shareholders, corporate bonds give their holders a more senior claim to the firm’s cash flow to pay bond interest and principal payments. If bondholders’ claims cannot be met, then default and bankruptcy may occur. The firm could be forced to sell or liquidate, and equity ownership could pass to its creditors and bondholders. Such events are usually very difficult, slow, and distasteful processes.
Figuring out whether bond obligations are likely to be fulfilled by issuers during the term of the bond is best left to professional bond investment specialists. This is called the default risk. Expectations about the varying potential for default can cause substantial price differences for bonds that otherwise have similar terms.
Investors can achieve higher returns by choosing the lowest cost bond market index funds
No load bond funds also can also provide a very high degree of fixed income securities investment diversification, and no load mutual funds can do this very economically. For individual investors it simply is much more straightforward to hold bonds through a bond fund.
Once a bond fund establishes its “style” for the type, maturity, and quality of bonds it will hold, it purchases and holds bonds with an eye toward maintaining that style. Maintaining targeted maturity is relatively straightforward. Determining investment quality is less straightforward, but bond mutual funds have analysts on staff and have access to the analytic services of bond ratings houses like Moody’s, Standard and Poor’s, and Fitch Ratings.
Bond market index funds offer a far higher degree of investment portfolio diversification
No load bond funds provide the investment risk reduction associated with market diversification. Investors can achieve fixed income securities diversification far more economically than they could through the direct purchase of individual bonds.
Fixed income mutual funds offer additional trading efficiency advantages to individual investors. The professional traders of bond mutual funds can conduct fixed income securities trading much more efficiently. Furthermore, fixed income funds trade substantial volume, which gives them leverage in negotiations and the ability to trade with different partiesthe. Individual investors have no such leverage, and they must take or leave the price they are given. Therefore, individuals buy at retail prices and sell at wholesale prices — often paying substantially higher spreads than professional fixed income securities traders do.
Without knowing it, bond market trading of individual fixed income securities can be very expensive for individual investors. Individual investors simply cannot tell whether they are getting a fair market price. Sometimes, individual investors pay very high spreads and transaction expenses, when they buy or sell individual bond securities. This is not an issue of bond market inefficiency. Rather, it is a problem of grossly unfair treatment aided to the obscurity of the bond market pricing process and the willingness of certain traders to take full advantage of individual investors.
