Bonds have historically been an extremely important part of an investor’s portfolio. They provide relative value stability when compared to stocks and a stream of income for the investor. We’ve previously talked about what bonds you can own (http://www.laurelfinancialgroup.com/content/different-breeds-bonds), but there is also the question of how to own them.
Basically, we have two options here: we can own individual bonds, or we can own them in some sort of investment product like a mutual fund.
Owning Individual Bonds
There are certainly advantages to owning individual bonds. First, you know what your return will be if you hold the bond to maturity. Your payments are fixed and, as long as the issuer is in business, you should get your money back when the bond reaches maturity. And even in the issuer goes out of business, bondholders are high on the capital structure, meaning you would be high priority on the company’s payback list and would likely recoup a fair amount of your principle, typically at least half.
That rosy hypothetical scenario sounds great but runs into more than a few complications when it meets the real world.
The first issue is finding this wonderful bond you’re going to own. Bond trading isn’t the same as stock trading. There aren’t just infinite pools of every bond you can think of floating around to be bought like shares of stock. Bonds come out in issuances and good deals are highly coveted. So large managers and pension funds who have relationships with the issuers will most likely gobble up most of what you would want to own before smaller shops can get any to sell to their customers. So supply is an issue.
Another big problem is the research that goes into what to buy. Bonds are agreements filled with terms called covenants, these covenants can dictate what happens to the price or income produced by a bond in certain scenarios, so they’re very important to understand. It’s also important to understand how likely it is for the issuer of the bond to deliver on those covenants and where that bond is in the capital structure if things go south.
And things get even more interesting if something changes in your plan and you have to sell the bond. At that point everything kind of goes to you know what.
So as great as the ideal scenario sounds, it is not easy to execute and can be overly constraining for many investors.
Owning Bond Mutual Funds
Bond funds may seem like a cop out to some, but this strategy addresses many of the negatives of owning bonds directly.
Funds give you access to managers and teams of analysts. It is these people’s life work to investigate the companies and the bonds they own and make sure that that bond will fall in line with the fund’s objectives.
The other benefit to these teams is that you can use one that works for one of the large shops we mentioned before. This gives us mere mortals access to quality bonds and quality pricing that wouldn’t be available to us otherwise.
One negative you’ll hear on bond funds is that they do worse than individual bonds when interest rates rise. To me this is a misrepresentation of the facts. When Interest rates rise quickly you certainly could see a drop in the price of the bond fund. This however is just giving you up to the day pricing on the bonds inside. I think we’ve all heard Wes say the “You don’t check your home price every day” adage. Well the same holds true here. That price you’re seeing fluctuate is what you would get if you sold the fund. If you were looking to sell your individual bond every day you would see similar, if not far more price fluctuation. This can actually work out to be an advantage of a bond fund, since you know what you can get for your investment immediately if you need the principle back early rather than shopping it around on the open market like an individual bond.
Funds do come with expense ratios, but those are paying for the teams spending their time to select what goes in the fund.
If you noticed, this fund portion is talking about mutual funds and not ETF’s for a reason. I know we can sound antiquated, but the jury is seriously out on bond ETFs. And this is for a very big reason: ETFs mirror indices and you can’t actually own the bonds in a bond index. We talked earlier about how bonds come out in issuances so once the January 2018 treasuries are bought up, they’re gone until someone wants to sell one. An index may track the value of that bond as part of the market, but it won’t be able to buy that exact bond. Index funds can only work to replicate the overall makeup of the index using basically whatever they can get their hands on quickly. They’ll try to assemble some stuff that mimics the yield, duration, and credit quality of the index and “voila” you have your fund. Yea, sounds good to us too (sarcasm).
This information only scratches the surface of the technical world of bonds, but we think it is good to know when considering how you’d prefer the fixed income part of your portfolio to look.
Bonds are subject to availability and market conditions; some have call features that may affect income. Bond prices and yields are inversely related: when the price goes up, the yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity.