I received a question after my last post regarding bonds and just to clarify, I was referring to owning individual bonds. The person that asked the question, like many investors, has exposure to bonds in his portfolio via bond funds which can be a mutual fund, exchange traded fund (ETF) or closed-end fund, so I thought it would be a good idea to discuss a few key differences between owning individual bonds vs. bond funds.
There are pros and cons to each approach, but individual bonds are a lot simpler to understand so we’ll start there.
Individual Bonds
An individual bond is a loan to one specific entity with stated terms like the rate of interest to be paid, how often is the interest paid, the maturity (repayment of principal), and any unique features like the ability to repay the loan before the stated maturity. Individual bonds work great from a cash flow matching perspective because an investor is able to match the maturity of the bond with the timing of expenses. A very common approach to investing in bonds is to stagger the maturities each year across a timeline – something called laddering or building a bond ladder. This might be done for a few reasons but generally it provides a higher average interest rate while reducing certain interest rate related risks, leaving credit risk (bankruptcy or default on the loan) as the main risk to evaluate. It also ensures you’ll have an inflow of cash each year which you can use to either spend, reinvest in a new bond to mature at the back-end of the ladder, or purchase stocks if they’re at attractive prices.
Let’s look at a simple example of this for retirement planning. If someone is planning to retire in 10 years, they could purchase a bond equal to the amount of income they’ll need from the portfolio to mature in 10 years. They will then buy a new 10 year bond every year moving forward to build their bond ladder. Upon retirement, the first 10 year bond matures providing the money needed for living expenses. Next year, the next bond matures, and so on. The benefit to the retiree is that they have already established their income and their ability to retire won’t be affected by other investment risks – like a falling stock market. The retiree has also established a portfolio where they have bonds maturing each year but are paying interest at 10 year rates, which are typically about 2% higher than short-term rates.
Bond Funds
Bond funds bring in a few extra risks which are important to understand and manage. There’s one in particular though that I’ve found most investors to be unaware of but extremely important to understand so hopefully this post will shed some light.
Funds were created to offer diversification and professional management to investors by “pooling” their money together so they can purchase a few hundred different bonds instead of just one. Most funds will have a stated objective which the manager is bound to. For example, the fund’s objective might be to invest in long-term investment grade corporate bonds. This way the investor is able to pick the type of fund that fits his/her investment goals. However, this can add a significant degree of interest rate risk since bond prices and interest rates move in opposite directions. If you hold a bond to maturity, you don’t have to worry about this. However, since the fund manager is only allowed to own long-term investment grade corporate bonds, he/she will need to sell bonds as they approach maturity and would then be considered intermediate-term or short-term, thus ensuring all bonds in the fund are always “long-term bonds.” This means the fund never holds a bond to maturity and is subject to changes in interest rates. If interest rates rise, which is currently a concern given today’s low rates, a bond fund can lose value as the price of the bonds fall. It’s even possible to lose more in value from the drop in price than you earn in interest in a year. Conversely, you can experience price gains if interest rates fall. Just keep in mind that the longer until maturity, the greater the change in price due to a change in interest rates, meaning long-term bonds are more price sensitive to interest rate changes than short-term bonds.
Funds also add an extra layer of expense to your portfolio. You’re paying for the fund manager/research team, trading expenses, and often times taxes on unwanted distributions each year.
It’s important to weigh the pros and cons of each approach before investing. If you’re comfortable with the credit risk of lending to one specific entity, individual bonds can be a much more effective (and cheaper) strategy. However, if you’re more comfortable with the diversification of a fund, or if that’s all you have available (e.g. within a 401(k) plan), just make sure you understand how changes in interest rates can affect your returns each year.
Thanks for following!
-Nick
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