Bonds are a good way to diversify your portfolio and smooth out the volatility in your stock holdings.For convenience’s sake, many investors turn to bond mutual funds, instead of holding individual bonds. That may be a bad choice.
For the fixed-income portion of your portfolio, you should buy individual bonds rather than bond mutual funds for three main reasons.
1. If you buy actual bonds and hold them to maturity, you know exactly what you’re getting and don’t have to worry about losing money.
2. You get regular interest payments.
3. You don’t have to pay the high expense ratios bond mutual funds charge.
Typical bond owners rely on their investment portfolios to provide income for living expenses, or if they have large financial obligations coming up in the near future (such as the down payment on a house, a new car purchase or sending their kids to college).
But suppose there’s a short-term drop in your portfolio’s value because the stock market takes a downturn. You need your bond investment to offset the stock portion’s weakness.
If that doesn’t happen, you might end having to sell equities from your portfolio right after suffering a big loss. This can be potentially harmful in the long run because it depletes your portfolio’s capital at the worst possible time.
Bond funds do not provide the same stability that you get with individual bonds. The net asset value (NAV) of bond funds changes every day in response to market conditions, just like stocks. These fluctuations are often very small, but they are cumulative, and a major event could cause a significant drop in the NAV.
Outlier events can hammer bond funds. Sector-specific or long-duration bond funds are even more volatile. For instance, high-yield bond funds suffered in the early 1990s. Funds specializing in long-term obligations get hurt the most when interest rates surge.
Depending on the restrictions of the bond fund, the managers may sell bonds at a loss, or worse yet, be forced to hold on to the bonds as the fund NAV continues to decline. For example, the Barclays Aggregate’s rolling four-quarter return was 9.2% in the red at the end of 1979, a terrible performance for a bond fund. Of course, this decline occurred when the Consumer Price Index soared to more than 14% from 6%, and rates shot up as a result.
Just because you own an individual bond and plan to hold it until maturity does not mean that its value doesn’t fluctuate. All bonds move in response to daily changes in interest rates, credit conditions and a host of other variables. Daily events can cause a bond to drop in value. If you need to liquidate a bond on a bad day, you suffer a capital loss.
But if you hold the bond to maturity, this short-term decline isn’t an issue. Price fluctuations mean absolutely nothing to you. You just sit back, collect coupon payments, and get your money back at maturity.
The crux of the argument for individual bonds is that you don’t plan to sell them. This way, you know the value you are virtually guaranteed to get at the end of the period, while a fund owner doesn’t. It comes down to simply not looking at the value of a bond along the way.
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Russell Francis, CFP, CPA, is the owner of Portland Fixed Income Specialists in Beaverton, Ore. His website is http://www.pdxfis.com.