There are a number of costs you should be aware of before you invest in bonds. The costs of investing in bonds can be divided into three categories: explicit costs, implicit costs, and hidden costs.

Explicit Costs

Explicit costs are the costs that you see (or should see) on your brokerage account statement. These costs include commission costs, markup, and custody fees.

All bond trades incur commission costs, which are fees that are paid to the broker who arranged a purchase or trade. Some newly issued bonds may be sold to the investor without commission costs if the issuer absorbs the commission costs; however, most trades incur commission costs. Costs can either be fixed (e.g., $15 per trade), or a percentage of the purchase or sale amount (e.g., fifteen basis points, or .15 percent of the trade).

Markup is the difference between the price you pay for the bond and the suggested selling price.

Custody fees (annual fees) are fees that the brokerage house charges you to hold bonds in your account. These fees may be a specific amount for small accounts (e.g., $15 per year). For larger accounts, the custody fee may either be assessed as a specific charge per holding (e.g., eight basis points per security, or .08 percent), or a percentage of your assets (e.g., twenty-five basis points per security).

Implicit Costs

Implicit costs are costs that you may not see until months after you sell a security. The most common implicit cost is taxes. It is critical that you account for taxes when you are valuing the true return of your portfolio. Implicit costs such as taxes are not noted on your monthly report, and most investors do not think about them until they have to pay them. Understand taxes before you begin paying them.

The interest you receive from bonds each period is taxed at your ordinary income rate. Interest is an expensive type of income.

The amount of your capital gains is equal to the difference between what you paid for a bond, or the principal, and what you sold the bond for. In other words, capital gains are the difference between what you paid for a bond and the par value of that bond if it is held to maturity. Short-term capital gains are made when you sell bonds you have owned less than one year. Short-term capital gains are taxed at your marginal tax rate. Long-term capital gains are made when you sell bonds that you have held for more than one year. Long-term capital gains are taxed at between 5 and 15 percent, depending on your income level and how long you have held the bond.

Hidden Costs

In addition to understanding explicit and implicit costs, you should be aware of the hidden costs involved in investing in bonds.

• Account transfer fees: These are costs for moving assets in or out of an existing account.
• Account maintenance fees: These are fees for maintaining your account.
• Inactivity fees: These are fees for not having any account activity over a certain period of time.
• Minimum balance fees: These fees are charged when you fail to maintain the required minimum balance in your account. Make sure you know what the minimum balance on your account is.
• Interest on margin loans: This is interest charged on money you borrow to buy securities.
• Selling charges (loads): These charges are commissions paid to a broker for helping you purchase certain securities, mainly load mutual funds.

Suggestions for Investing in Bonds

If you are investing in bonds, it is important that you adhere to the following investment principles:

• Know yourself and your goals: Match the maturity length of your bonds with the investment time horizons of your goals. If you match the maturity length of your bonds to your goals, you can minimize your interest-rate risk.
• Stay diversified: Rather than buying a single bond, invest in a portfolio of bonds. Your portfolio will suffer less of a negative impact if one of the bonds declines in value. If you must buy single bonds, buy only high-quality bonds.
• Invest tax-efficiently: Remember, it is not what you make but what you keep after taxes and inflation that is important. Account for the tax implications of investing in bonds. Prior to investing in bonds, you should calculate the after-tax yield for all taxable bonds and the tax equivalent yield for all tax-advantaged bonds.
• Minimize costs: If you can, buy bonds when they are first issued rather than buying them in the secondary market.
• Watch the market interest rate: Keep in mind that as the market interest rate rises, bond values fall, and vice versa. If interest rates are likely to rise, invest in short-term bonds; if interest rates are likely to fall, invest in long-term bonds.
• Know what you are investing in: If you are investing in individual bonds, make sure you understand the companies whose bonds you are holding. If you do not have the time to investigate individual companies, purchase a bond mutual fund that is well diversified. Avoid buying bonds that are callable.

 

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