Better to Hold Treasury Bonds Outside of Funds

It will be interesting to see if the federal government misses an interest payment or two on outstanding Treasury bonds because of the battle over the budget and debt ceiling. For years, Washington has been regarded as the world’s most credit-worthy bond issuer, but any default would tarnish that image.

Bond investors seem to view the stalemate as a political tangle rather than a sign of insolvency and don’t appear alarmed by it. Even so, the impasse provides one more reason not to invest in mutual funds that have big holdings in Treasury bonds.

Treasuries are, of course, a prominent feature on the investment landscape. Shareholders have $8 billion socked away in 65 Treasury-bond mutual funds tracked by Morningstar Inc. of Chicago. Treasuries also make up more than $30 billion worth of assets in other bond-fund categories.

Yet compared to other types of investments, it’s less important to hold Treasuries inside of mutual funds. Here are some reasons you might want to buy individual Treasury bonds rather than funds, or to forgo this asset category altogether:

* Diversification isn’t so critical. A key reason to invest in any mutual fund involves the ability to spread your dollars among various stocks or bonds. Diversification lessens the danger that one rotten apple will stink up your entire fruit cart.

But Treasury bonds don’t rot because the federal government doesn’t go bankrupt. Notwithstanding the current stalemate, Treasuries are the safest investments you can make in terms of recouping your principal and receiving interest payments on time. With Treasuries, there’s little need to seek safety in numbers.

* Volatility can be high. Treasuries are safe from a credit standpoint but perilous in terms of interest-rate risk. In fact, Treasuries are more vulnerable to rate fluctuations than any other bond type. Last year, Treasury portfolios fell 4.1% on average, compared to 3.3% for taxable-bond funds generally, reports Morningstar.

* Fat fees are harder to justify. On average, Treasury-bond funds charged shareholders 0.73% in expenses in 1994, according to Morningstar. That’s equal to $7.30 for each $1,000 a person invested. Those costs were a bit below what other bond funds levied. But you could argue that they should be even lower because Treasuries are cheaper for portfolio managers to trade and to research.

The Vanguard Group of Valley Forge, Pa., offers three Treasury-bond products under the Admiral name. These funds won’t accept shareholders with less than $50,000 to invest, but at least they show what’s possible from a cost-cutting standpoint: Their expenses run just 0.15% a year.

* Individual-bond transaction costs are low. Portfolio managers can trade stocks and most types of bonds for much less than individuals can, since funds enjoy huge commission discounts. But this advantage doesn’t weigh so heavily with Treasuries, which investors can buy for free through the Federal Reserve System’s Treasury Direct program. (California residents can call [213] 624-7398 for information.)

* Treasuries pay lower yields. Investors can expect to earn more income on other types of government bonds as well as on corporate, municipal and foreign debt. Given their weaker credit standings, other bond issues must offer higher yields than Washington to lure buyers.

It’s thus somewhat ironic that Treasury funds have outperformed taxable-bond portfolios in recent years, but this can be explained by a favorable interest-rate environment over the stretch. When rates are stable, riskier bond funds can be expected to deliver more.

If the above arguments haven’t discouraged you from buying Treasury funds, you should at least narrow your picks to less-costly portfolios that avoid long-term bonds. There’s no good reason to pay high fees to a portfolio manager working with such plain-vanilla investments as Treasuries. And at today’s low yield levels, there’s little reason to take on extra risk with long-term bonds.

Funds showing lower costs and less volatility include the Dreyfus 100% U.S. Treasury Intermediate-Term Fund ($2,500 minimum; (800) 648-9048), T. Rowe Price U.S. Treasury Intermediate ($2,500; (800) 638-5660) and Vanguard Fixed- Income Intermediate-Term U.S. Treasury ($3,000; (800) 662-7447). All are commission-free products.

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A record 60.6% of money-market mutual funds waived some expenses to pump up yields during the third quarter, reports IBC/Donoghue Inc. of Ashland, Mass. But only three of 1,128 money funds tracked by the firm waived all costs.

Money-fund expenses averaged 0.58% on an annualized basis, equal to a charge of $5.80 for each $1,000 investment.

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Cognizant of the market’s lofty valuation, portfolio manager Richard Dahlberg is stressing income over appreciation for the new Salomon Bros. Total Return Fund ([800] 725-6666; 4.75% maximum sales charge), which was launched in September. Dahlberg has only 45% of the fund’s assets in stocks, below the 50% or higher levels typical of balanced portfolios. High- quality and lower-rated corporate bonds each make up 20% of the fund’s assets, while convertible bonds and cash round out the portfolio.

More interesting, Dahlberg says he intends to pay monthly dividends in January--an unusual twist for a balanced fund, most of which pay quarterly. The New York-based portfolio also will offer a rather high 4% yield, compared to 2.8% for balanced funds generally.