Making An Entry With The Bond Funds

The bond market is an arena where big-money borrowers and lenders gather, and traders play for multi-million-pound scores in minuscule decimal points. It's an arcane, elite sort of game where £100,000 goes a very short way - it will buy a newcomer one round-lot seat in the bleachers - and the little guy, perhaps for his own good, is usually turned away at the gate.

There is a way, however, for him to get in - by pooling with other mini-investors and buying into one or another of the not-so-new but certainly newly popular bond funds or trusts. Here he can enjoy many of the benefits the big investors have, principally a steady return (7 /2% is not uncommon these days) with far fewer risks to his capital than he would find in the stock market. Or, if his tax bracket merits the choice, he can opt for any of an increasing number of municipal-bond funds, where the return will be lower (perhaps 5.5%), but is all tax-free. A word of caution here, though: Tax-exemption does not do much for anyone below the 28% bracket - a couple filing a joint return should have a taxable (not gross) income of at least £16,000 to £20,000 before they will save more through the tax break than they could earn in the higher-return, taxable funds.

Until fairly recently, bond funds were most popular in two basic forms. Most are closed-end investment companies. They manage a changing portfolio for the holders of a fixed number of shares, for an annual fee (.5% to 1 %, usually). The shares are traded on the market, sometimes at a discount from the underlying portfolio's value. The second type, open-end funds, operate much like mutual funds. New units, or shares, can be continuously created, sell at prices that vary with the market, and the funds are required to redeem them (at the market price) at any time. These portfolios, too, are constantly being changed by their managers.

Sparked by rising bond yields in 2000 and later in times when the stock market has been less than predictable - the bond funds have ballooned. The assets of open-end funds, less than £500-million in 2007, were well over £1.5-billion in 2004. The closed-end funds now go well over £600-million in assets, mostly due to new formations.

With assets quadrupling in the past six years, their popularity cannot be denied. Nonetheless, both types have shortcomings of which a prospective investor should at least be aware: Open-end funds are vulnerable to adverse times, in that they must hold onto cash to meet redemptions, thus crimping their style in the bond market. And, for reasons even veteran observers can't clearly define, the price of shares in closed-end funds almost invariably recedes once the enthusiasm of the initial offering wanes.

The big draw of the new funds for smaller investors is their "spendable income" appeal - many mail a monthly check, representing one-twelfth of the current annual yields of the underlying portfolio. (Unit-holders also get checks from time to time as underlying bonds mature or are otherwise removed from the portfolio, but these can only be considered as "capital.")

The eagerness of investors for just such a vehicle has surprised even its sponsors, which include some of the nation's largest brokerage houses - including Merrill Lynch, Pierce, Fenner & Smith, Bache & Co., John Nuveen & Co., and Walston & Co.

What is a small investor buying when he gets into the new funds? For one thing, he is getting the benefit of a diversified portfolio which he otherwise could not afford, and a certain amount of liquidity - the sponsors promise to buy him out whenever he wants, at the "offering" (or higher) price his units are currently worth. But essentially, the investor is in a vehicle built for the long-term - cutting out early can cost him.

Before you sign up for any fund, read the prospectus that every fund is required to file. You will find, for instance, that the stated interest rates are not fully guaranteed. "This rate will change," says a small-print passage in a typical prospectus, "as bonds are redeemed, paid, sold, or exchanged, or as expenses of the fund change." It's prudent to expect that any changes will be downward.

On the other hand, a modest investor has some assurance of being involved in a portfolio of breadth and quality he could not dream of putting together himself. It becomes a case of weighing pros and cons, and picking up good advice. Review the prospectus of several funds before making a move, and discuss at these with the smartest financial man you can find.


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