Bonds are usually considered the safe portion of an investment portfolio. But investing in bonds can yield some unpleasant surprises.
The bond market has dynamic quirks of its own and can require sophisticated investment strategies, particularly in today’s interest rate environment.
Bond fund or individual bonds?
The bond market is extensive. Institutions of all kinds issue bonds to raise money. The easiest for individuals to buy are Treasury securities.
It gets a little more complicated to buy bonds issued by businesses, local governments or private institutions.
Retail investors compete against institutional investors as well as investment professionals who buy large lots of bonds for their clients. That means the best bonds may never be seen by individuals. And if they are seen, the price may not be as good as it is for people buying larger quantities, and trade execution can be a little slower.
Buying individual bonds allows investors more control over their investments, but as with individual stocks, their investment portfolios need to be sufficiently large to accommodate the number of bonds necessary for proper diversification.
You have to be very careful about saying, ‘I’m going to only buy one bond, and it’s going to be a big part of my portfolio. The idea is that you want some diversification. I would suggest looking at corporate bonds — 10 different issuers at least. If someone has $50,000 to do this, they may be better served by using a bond fund.
Attributes of bond funds
The disadvantage of bond funds is their ongoing fluctuation in price. Whereas a highly rated individual bond purchased at par value can be held to maturity with no apparent loss of principal, bond funds, which constantly buy and sell bonds, are priced daily. This means they’re subject to price fluctuation, and investors can lose money.
An investor who holds an individual bond to maturity can ignore all price changes that would affect selling the bond on the secondary market. Barring default, the investor will receive the face value at maturity.
Rising interest rates can also negatively affect the price of the bonds in a fund. As interest rates go up, so will the coupon rate on newly issued bonds. The price of existing bonds will fall because their interest rates are lower, so investors are compensated for the discrepancy when they purchase those bonds at a discount.
The prospect of high turnover is one argument against getting into a bond fund today. Following a stampede into bond funds can backfire when the stampede heads out.
Diversified approach to reduce risk
As is the case with equities, trying to time the bond market doesn’t always work in favor of investors. One stress-free way to get into the bond market is with dollar-cost averaging and a diversified strategy.Bonds with long maturities are more impacted by rising interest rates than short-term bonds.
In this challenging economic environment, paying investment professionals to find the best bonds can be worth the cost, whether that means buying a bond fund or enlisting the services of a good financial adviser.