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Bond investors often wonder: If you’re concerned
about the prospect of rising interest rates crunching
your bond fund, why not opt for individual bonds
and hold them until maturity? Provided you purchase
a bond from a creditworthy issuer, you can simply
collect your income stream and then get your prin-
cipal back when the bond matures, regardless of
the interest-rate climate. Bond-fund holders, by con-
trast, won’t necessarily be assured a return of their
principal, and the interest they receive from their
bond funds could also fluctuate. A period of rising
bond yields has the potential to depress the prices
of already-existing bonds in a bond fund’s portfolio.
That, in a nutshell, is why so many investors have
been touting the value of individual bonds versus
bond funds lately. Given that interest rates have a lot
more room to go up than they can go down at this
point, there’s an increased chance that the bonds in
a bond portfolio will decline in value over the time
that you own a fund. Individual bondholders won’t
have to contend with that same issue. If they invest
$
100
,
000
in a bond and the issuer makes good on
its debt, the amount they put in is the amount they
get back.
At the same time, it’s unwise to derive a false sense
of security from investing in individual bonds. You
often hear professional management touted as a key
virtue of mutual funds. That’s because, in addition
to evaluating bonds’ interest-rate sensitivities, bond-
fund managers also spend time evaluating bond
issuers’ creditworthiness as well as other features of
the bond. Individual bond buyers may have difficulty
finding reliable independent information about less-
liquid bond issues from smaller entities and munici-
palities, and they may also have trouble evaluating
the features that are specific to that particular bond,
such as whether it’s callable and how much extra
income they should receive if it is. And even if they’re
sticking with more-liquid bond types, they may not
have the time or inclination to conduct the research
they need to assemble a well-diversified, high-
quality portfolio.
That brings me to another hurdle that individual bond-
holders face that fundholders do not: the difficulty
of building a well-diversified portfolio without a
whole lot of money. Bonds are typically issued with
face values of $
1
,
000
, but you may need to buy a
block of several bonds to obtain decent pricing. To
assemble an individual-bond portfolio that’s reason-
ably diversified across market sector, you would
need to have a pretty good chunk of change; $
100
,
000
is often bandied about as the minimum threshold
for a portfolio of individual bonds to make sense over
a bond fund. By contrast, bond-fund investors can,
without a lot of money, readily obtain access to a div-
ersified portfolio of bonds—corporate bonds, gov-
ernment bonds, asset-backed bonds like mortgage-
backed securities, as well as munis—thereby
reducing the damage that any one holding can inflict
on their overall portfolios.
In a related vein, individual bond buyers, particularly
those without a lot of money to invest, can face high
trading costs when transacting in individual bonds;
even investors buying many thousands of dollars’
worth of bonds may face much higher bid-ask spreads
than institutional buyers who are trading millions
might pay. Thus, even though the mutual fund man-
ager levies a management fee, the manager may
be able to make up that amount by swinging more-
favorable trading costs.
Finally, even though holding a bond to maturity can
offer some protection from interest-rate hikes, indi-
vidual bond buyers are giving something else up: the
flexibility to swap into higher-yielding bonds as they
become available. Even if interest rates trend up
before their bonds mature, they’ll have to stick with
their lower-yielding bond until it matures if they
want to receive their money back. The ability to easily
and efficiently swap into higher-yielding bonds
is an advantage bond funds have that holders of indi-
vidual bonds do not.
œ
Contact Christine Benz at
Why Funds Beat Bonds
Income Strategist
|
Christine Benz
