Bonds and bond mutual funds

Dear Dr. Don,
What is the difference between a bond mutual fund and a bond?
Larry U.S. Bonds

Dear Larry,
Bond mutual funds invest in a portfolio of bonds. By investing in multiple securities, the fund reduces the risk to the investor by diversifying away credit risk. If you invest $1,000 in a bond mutual fund and one of the bonds in its portfolio defaults, you would lose a fraction of your investment. If you invest $1,000 in an individual bond and it defaults, you could lose your total investment.

Selling individual bonds is problematic. Your broker has to price the bond so he can sell it to the next investor at a profit. If he prices it so there is $50 to $75 in it for him, then your return on investment goes way down. On a $1,000 bond, $50 is 5 percent. In today's market most corporate bonds are yielding less than 8 percent. If it costs you 5 percent to get out, you've just lost 63 percent of this year's interest income on the sale. For that reason, most individual investors should follow a buy and hold strategy when investing in individual bonds. The good thing about owning individual bonds is that you aren't paying annual management fees to the mutual fund. Those fees act as a drag on your return every year, not just when you sell.

Investors can buy new issue corporate and municipal bonds without a brokerage commission since the issue is paying a sales commission to the broker. However, most brokerage firms charge $50 to $75 for U.S. Treasury bills, bonds or notes. You could buy directly from the Treasury using Treasury Direct but that route makes sense only if you plan to buy and hold the security.

Cash purchase of home

Dear Dr. Don,
I am retired and my wife is near retirement age. We have about three years left on our mortgage. We will have a retirement income of about $70,000 per year before taxes without our IRAs, 401(k)s, etc. We are considering building a new home for cash. Does this make sense from a tax point of view?
Marty Mortgage

Dear Martin,
Having a mortgage reduces your income taxes because the interest expense is a tax deduction. That deduction becomes less valuable if, in retirement, you drop to a lower tax bracket.

By paying cash, you'll have no interest expense and you may be able to negotiate a lower price for the home. What you lose is the tax deduction and the flexibility to invest the purchase price, less any down payment, in an alternate investment. You've made an investment in real estate and that investment will earn a return, as long as the property appreciates in value.

Alternately, let's say you take out a 6-percent mortgage and that you are in the 25 percent federal tax bracket. Your after-tax cost of debt is 4.5 percent. If you invest in stocks, bonds or any investment that has an after-tax return of greater than 4.5 percent, you are increasing your wealth. You could get a bumper sticker that says, "We're adding to our children's inheritance." You also have leveraged your real estate investment. Any appreciation in your home's value accrues to you, not to you and the mortgage lender.

Some retirees, after a lifetime of mortgage payments, want to get out from under that monthly payment. Or they don't like the uncertainty or stress associated with investing the money they would have used to pay off the house. The tax deductions the mortgage generates shouldn't be the deciding factor in determining whether you take out a mortgage. How you plan to invest the money and your comfort level in taking this approach should be the deciding factors.

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-- Posted: Oct. 15, 1999