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Bond Funds

Investors are taking a second look at their bond transactions, questioning not only the bond losses but also how much they're being marked up by the brokers selling them.

Findings of a recent study conducted by Koski Research for Charles Schwab Corporation showed that of the investors surveyed some 44% could not figure out what the mark-ups on their purchases were and 24% didn't know how the firm they purchased the bonds from was actually compensated.

The results are not surprising. The bond market is massive, and lacks transparency to boot. The Securities Industry and Financial Markets Association (SIFMA) estimates there is $35.3 trillion in outstanding U.S. bond market debt.

As reported Oct. 26, 2011 by the Wall Street Journal, while most retail investors probably stick with bond mutual funds, higher-income investors often find individual issues – those that have a set maturity date – more attractive. If the company doesn't default, they'll get their principal back.

"But unlike the stock market, where brokerage commissions are clearly delineated, in the secondary bond market, retail investors pay a 'spread' between the price at which the broker buys the bond and the price at which they sell it to the investor," the WSJ story said.

In the Schwab survey, 40% of the investors surveyed said they didn't know how to get the best prices on bonds; 38% said it was too complicated to go shopping for them.

Meanwhile, respondents perceived the average mark-up on a $1,000 bond to be $6 or $10. In reality, however, those mark-ups can run as high as $20, even $30 per bond.

More than lack of awareness about how much they're paying when buying bonds, investors need to contend with another reality: The very real prospect of a disastrous bond rout in the not-so-distant future.

A Sept. 14 article by Investment News offers insight into this financial prophecy. Faced with a sustained rise in interest rates, bond prices will fall "as their yields are less attractive compared with new bonds issued at the higher rate. The longer the term, or maturity, of the bond, the greater the interest rate risk, because investors are locking in yields for a longer period of time," the article says.

With current yields low, an inflationary shock of any sort could have devastating repercussions for investors, with rates spiking in response. In the Investment News story, Boston money manager Ben Inker calculated what the damages might be if, for instance, yields on Treasury bonds went up just three percentage points, driving prices down. The answer: A 23.5% loss for a 10-year Treasury bond and a whopping 40.7% loss for a 30-year bond.

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