The bond market has been an incredibly competitive one lately, which is no surprise given how people tend to gravitate towards bonds during poor economic times and/or periods of great volatility within the stock market.
For many investors, the question of individual bonds versus bond funds is one that keeps them awake at nights. Which part of the bond market is the one on which an investor should focus? To help you with your bond market planning, here are some things to know about individual bonds and bond funds:
- Individual bonds provide the investor a reliable source of income (investors typically receive the interest from these bonds twice per year) as well as the security of knowing that the initial investment (i.e. the principal) will be returned once the bond matures. However, individual bonds can be sold by the investor before reaching their maturity date.
- Investors can approach bond funds as they would the stock market. Bond funds are traditionally purchased by a group of people who pool their investment and then hand it over to a broker. While individual bonds provide a twice-yearly payment, bond funds usually offer payment on a monthly basis. However, that payment fluctuates more than an individual bond.
While many people have the misconception that it is easier to diversify with bond funds, in today’s interest rate and bond market environment, it is actually safer for an investor to purchase a few individual bonds and get less diversification than putting any amount of money into a bond fund.
The bonds in funds are always changing to keep the fund at a specific time frame so the investor never really knows what bonds their capital is invested in. With an individual bond, the investor knows exactly what is paying the principal and interest on each of their bonds. A 10-year bond fund has to keep that time frame, so in five years an investor will still own a 10-year fund with different underlying securities than when he or she first bought it. When an investor buys a 10-year individual bond, in five years that same bond will then be a five-year bond that will mature on a specific date.
With interest rates being as low as they currently are, it is very dangerous for an investor to put capital into a bond fund because when they want to get their money back, they will have to sell out of the bond fund which will be at a much lower price when interest rates begin to rise. With an individual bond when rates turn around, the investor continues to earn the original yield he or she bought the bond at and can reinvest their principal at the current rates when the bond matures.
- When buying a bond fund, it is always important to ask the broker what issuers are the underlying securities from, what is the revenue for these securities, and what ratings do the underlying securities have. This way the investor is fully aware of what he or she is putting his or her hard earned capital in to. It is also important for the investor to ask what fees are associated with the bond fund as most funds have a lot of fees that will eat into an investor’s profit. Bond funds are known for being highly lucrative for brokers or salespeople.
An investor should also ask the broker what the SEC yield is when buying a bond fund. Many brokers quote the current yield of the fund which is almost always higher than the SEC yield, which is the true return on the investment. When buying individual bonds the SEC Yield or yield to worst case scenario is nearly always quoted to the investor.
For someone that is concerned with diversification, it is a common misconception that an investor can get more diversification through a bond fund; this is not true.
When an investor buys a few different individual bonds, he or she is basically creating their own fund. The investor can tailor their portfolio or ‘created fund’ to his or her specific investment goals by picking and choosing the specific bonds that go into the portfolio. Not only will the investor get excellent diversification and have a portfolio fitting their specific needs, but he or she will know the true quality of each security he or she owns.
The bond market is a challenging place for investors of all ages, experience and income brackets, as is the decision whether to invest in individual bonds or bond funds. Regardless of what you do, bond market education is the key, so make sure to read up on all facets of the market before you make an investment!