By not knowing the common pitfalls of investing in municipal bonds or bond funds you may be making a serious financial mistake. The accrued interest on municipal bonds is free from federal tax and also from state and local tax if you buy bonds issued by the state you reside in. While accrued interest is tax exempt, any profit realized from the sale is not exempt from taxes.

Buying bonds may appear straightforward, but if you want to avoid potentially major losses and hidden costs, you need to know how much and why bond values change when interest rates change and how brokerage firms can overcharge or add hidden markups when they sell you a bond. Other concerns include liquidity, or the lack thereof. Market timing is also a consideration, especially at this point in the interest rate cycle.

How much price risk are you taking?Fixed-rate bond prices are best thought of like a seesaw. The further out you sit, the wilder the ride. Near the center the moves up or down are usually calmer. The same principal applies to fixed rate bonds. For two bonds with the same annual coupon, the longer the maturity, the greater the price risk. In addition, price risk is inversely related to changes in interest rates. When rates fall, fixed rate bonds increase in value and viceversa.

In common market parlance, modified duration is used as an approximate measure of interest rate risk. Rather than worry about some technical measure, you simply need to ask for a price sensitivity analysis before buying a bond. This analysis will show you the approximate price change for a 1% or 2% immediate change in interest rates. Now that you understand how much price risk you are incurring by stretching out 25 years to earn a 4.5% yield, you may not want to buy that bond.

But why should you be worried about price risk if you intend to hold the bond to maturity? Won’t you receive your principal at maturity? Yes, is the simple answer. In the meantime, if you need to sell the bond to generate liquidity, the price may have changed. That’s great if yields have dipped and your portfolio has appreciated, but not so great when rates have risen and the value of your bonds has dropped.

How about default risk and liquidity? Aren’t all AAA-rated bonds the same quality? The short answer is “no.” First, stick with high quality bonds. The one mistake you make in buying a lower quality bond can wipe away years of additional yield in a single downgrade. But, a AAA-rating doesn’t necessarily insure liquidity. Lower quality issuers generally buy insurance to enhance their credit rating to AAA, thereby lowering their overall cost of financing. Just like thinly traded stocks on the NASDAQ, smaller issues and certain types of issuers like hospital or housing revenue bonds are considerably less liquid than general tax obligations (called GOs).

Does liquidity then equate to a hidden cost? Yes. What your broker isn’t telling you when you buy that hospital revenue issue is that the difference between the bid-ask is 3%. The bid is the price the market is willing to pay you for a bond and the ask is what you pay when you buy it. Also, in periods when yields are rising rapidly, dealers may discount their bids to build in an extra cushion as a hedge against their inability to sell a bond before rates increase further. One way to protect yourself from buying less liquid issues is to ask your broker to disclose the approximate bid offer spread.

Does paying a fee for the management of your bond portfolio protect you from hidden markups? The answer depends on the firm you work with. If you routinely receive a letter notifying you of your right to refuse a bond purchased for your separately managed portfolio, then you may be paying an additional markup on each purchase. You should discuss this type of hidden markup with your account rep.

As for fees, how much is too much? You shouldn’t pay much for the management of a fixed income portfolio. A fifteen to fifty basis point fee, depending on portfolio size and investment objective, is generally appropriate. Another option is agreeing to a fixed amount of markup on the purchase of a bond. By negotiating this type of management arrangement, there should be no hidden markups. Either way, making sure there are no hidden costs can greatly decrease the uncertainty associated with your fixed income portfolio.

What else should I consider at this time? Lastly, and most importantly, market timing can have a devastating impact on your total return over the next couple of years. Table 1 displays the average return on portfolios comprised of general market, AAA-rated 5, 10, 15 and 20-year maturities. It is interesting to note that you are not paid a lot more for 20 year bonds on average versus 5 year bonds. When you review the price risk of longer-term bonds, however, you find that you are taking over 3 times as much price risk on 20-year bonds versus 5-year bonds for the same change in interest rates. If the primary objectives of a fixed income portfolio are to provide safety of principal and predictability of income inflows, then invest in AAA rated, high quality bonds and target shorter durations. In our opinion, longer duration bonds and issues with lower credit ratings generally do not provide enough of a yield premium to warrant the additional price risk and loss of liquidity.

So, if you are going to take a price risk, is now a good time? The answer to this question is revealed when you review Table 2. As you can see, across the maturity spectrum of 5, 10, 15 and 20-year maturities, the current return is only about 25 basis points (0.25%) above the lows for the past 10 years. In addition, the current return is quite a bit lower than the average yield for the same period and is significantly below the highs. At these levels, investors may wish to sell longer duration bonds to avoid low or negative total returns if interest rates increase.

What do these two tables tell me? You don’t get paid a lot for taking price risk in the first place. Most importantly, right now may be a very bad time to stretch out to capture yield. In fact, if you own longer-term bonds in your portfolio, you may want to consider whether now is a good time to reevaluate your original decision to take on so much price risk. You may have a nice profit in these longer notes and you’ll find that with offsetting capital losses from your equity portfolios, you can justify a swap to shorten up bond portfolio maturity.

How about bond funds? Are they a better bet? Our opinion is, bond funds may not end up being the safe haven many investors are seeking. Investors, however, may want the reassurance that is provided to them by knowing that a professional is managing their portfolio.

As with individual bonds, bond funds have their own issues of which you must be aware (or beware) of.

Are there any hidden costs? The prospectus fully discloses any loads, management fees, and expenses. What isn’t disclosed, however, are imbedded capital gains. Remember that 13% total return in the past 12 months? It sounds great, but just like buying into an equity fund when the NASDAQ was at 4500, the bonds in the fund may have appreciated materially in the past year leaving the fund with a lot of unrealized gains.

As we move toward the end of the year, the fund manager may decide to capture gains before rates rise and prices decline. By buying in now, you pay the net asset value of the fund. You may have already missed most of the price appreciation (remember where we are in the cycle?). But, you could be stuck with your pro rata share of the capital gains distribution at year-end if the fund manager sells. This issue will sound very familiar to many investors who paid capital gains in 2000 despite suffering significant NAV declines.

How do you determine the price risk of the fund you are considering? Bond funds have a price risk associated with their portfolios that is similar to the underlying bonds. To get a sense of the price risk, simply ask for the fund’s duration. To get a rough estimate of the price risk, multiply the duration by the amount you expect rates to change over the next year and you’ll have a general idea of whether you can tolerate the fund’s price volatility.

Now that you know all this, what should you do? If investors wish to take more price risk to achieve higher potential returns, then they should consider the outlook for future interest rate movements relative to current yields. If current yields are near the low in the cycle, then we encourage investors to stay short or lessen the price risk in their portfolios.With interest rates as low as they are, taking a high degree of risk at this time is simply not prudent. Stay in shorter duration bonds and avoid bond funds with imbedded gains.

Over the past 10 years, investors haven’t been paid for taking a great degree of price risk with longer-term bonds. As for your relationship with your account rep, if you can’t get a square answer as to how much you are paying to buy bonds, perhaps you should consider working with someone else.

Also, if you are receiving a right of refusal letter whenever bonds are purchased for your separately managed account, you should definitely have a chat with the account manager.

Lastly, if you own longer-term bonds in your portfolio, now is an excellent time to consider whether you are being adequately paid for the risk to the value of your portfolio if yields rise.

Sanjeev Sardana is Vice President, Private Advisory Group, Credit Suisse First Boston. Andrew Hart is Director Private Advisory Group, Credit Suisse First Boston.