WHEN SHOULD YOU BUY a bond, when should you buy a bond fund?

That’s a complicated question about which volumes could be written, but fortunately there is a fairly simple answer available.

First let’s define the dilemma. The two important variables as you go about deciding whether to own bonds directly or indirectly are these: annual holding costs and liquidity.
Your annual holding cost is the percentage fee you incur to stay put in an investment. Liquidity is your ability to buy and sell with minimal transaction costs (commissions and sales charges) and minimal inconvenience.
There is, naturally, a tradeoff. An investment with a low annual holding cost is unlikely to offer the best in liquidity. Conversely, if you go for maximum liquidity you are inevitably going to pay some holding costs.

Penny Stock Funds

Example: You have $300,000 you want to put in municipal bonds. A muni bond fund from Vanguard has perfect liquidity: You can buy and sell with a phone call and there’s no fee or markup. But the annual holding cost is $600, in the form of a 0.2% fund expense ratio.

Alternative: Buy twelve $25,000 muni bonds yourself in a Charles Schwab discount brokerage account. The annual holding cost is $0. But the liquidity is terrible. You could run up a tab of $1,500 to $3,000 (in the form of hidden bid/ask spreads) to assemble the portfolio, and God forbid you need to cash in any of the bonds early. You’d have to pay those bid/ask spreads all over again.

US Treasury Bonds

Now here’s our formula. If you are buying U.S. Treasurys, stick with a no-load fund if you have less than $50,000; if you’re buying municipal bonds, stick with the fund up to $500,000; if you’re buying junk, foreign or exotic bonds, stick with the fund up to $5 million.
You can modify the break points in this rule of thumb to suit your own purposes. Here’s why we chose the numbers we did.

A portfolio of Treasurys can be economically assembled on your own even if it’s fairly small. That’s partly because diversification is unnecessary. Unlike other issuers, the U.S. government is default-proof. So you can safely put your entire wad into one issue. That keeps your transaction costs down.

Also, Treasurys are highly liquid. Because there are a lot of them outstanding and they are traded every day in huge volumes, their bid/ask spreads are narrow–often less than 1% even on a tiny $50,000 order.
You can get your costs still lower on a Treasury purchase by buying at a government auction. Schwab will handle the paperwork for $49.
If you’re really cheap, you can avoid even this $49 fee by dealing directly with a Federal Reserve bank. (We don’t recommend this method unless you are highly confident of holding the bond to maturity. Selling a bond held in a Fed account is slow and painful.) For more information on the Treasury Direct program, call the Bureau of the Public Debt in Washington at 202-874-4000.

Tax-exempt bonds are a little trickier

Diversification is definitely a matter of concern. As the bankruptcy of Orange County, Calif. aptly demonstrated, it’s a good idea to buy from some 20 issuers to hedge your bets. Bid/ask spreads are significantly wider than on Treasurys, and all but unaffordable on lots smaller than $25,000. That’s why we recommend a $500,000 minimum for a portfolio of individual bonds.

But lower this hurdle if any of the following apply:
You buy the munis at original issue, paying the same price as institutional investors and thus minimizing the transaction cost at purchase.
You intend to hold every bond to maturity, eliminating the transaction cost at the other end.

You buy only insured or AAA bonds, which are more liquid.
As for junk and exotic bonds, steer clear of do-it-yourself money management unless you are really in the big leagues. Bid/ask spreads, even for institutional-size trades, can be 5%. Default risk is high. Subtleties in the bond indenture may catch you unaware. You may need a computer to know whether the price quoted to you is even close to the fair value of the bond.

Have we persuaded you to put your fixed-income money in a fund? Then watch your costs. Don’t pay a sales load. Don’t pay more than 0.5% a year in expenses for a municipal or a high-grade taxable bond fund. You might go as high as 1.2% for a junk fund with an excellent performance record. See the table for Forbes’ Best Buys in bond funds.