April 27, 2022 – Given the performance of the bond funds in 2022, it’s a good question!
First, let me outline a couple of key principles of the markets in fixed income securities, also referred to as the bond market.
- A bond is a fixed-income instrument that represents your loan of money to a borrower (typically a government or a corporation) for a specific length of time (maturity). To incent lenders to give this “I.O.U.,” borrowers will provide a return on the money lent in the form of interest payments.
- Typically, a newly issued bond pays interest at a fixed rate, quarterly, until maturity.
- The value of your bond will change as interest rates rise or fall. As you would expect, if interest rates go up and similar bonds to yours are returning more interest to the lender, the value of your bond which is paying less interest will go down. Conversely, if interest rates are falling, the value of your bonds which are paying a higher rate of interest would increase in value.
- In conjunction with the change in interest rates, the remaining length of time until maturity will impact the degree of value gained and lost. The longer the time until maturity, the more sensitive the valuation will be given a change of interest rates.
- Finally, the creditworthiness of the borrower (their ability to pay back the principal you lent) has an impact on the valuation. That is why the US Government can borrow at the lowest rates, as compared to “junk bond” borrowers who have to pay lenders a higher rate of interest to take the risk that their principal might not be returned.
In today’s environment of rising interest rates,bond-fund holders are experiencing losses in their bond portfolios. As a bond-fund holder, you’re basically holding a basket of individual bonds, and those bonds’ values get tallied up every day. And what happens when interest rates rise is that the bond prices fall. What, indeed, has happened so far in 2022 is that some holders of bond funds have been ready to sell their funds and realize the losses. When bond fund owners sell their fund shares, the bond fund managers must sell the individual bonds they hold in order to pay the selling bond fund owners.
How could the scenario play out differently for someone who owns individual bonds rather than bonds through a bond fund? The virtue of that strategy is that if you buy a bond and the issuer is creditworthy, and they are making their payments, you are made whole at the end of that maturity – when your bond matures, you get your principal back. By holding the bond to maturity your original investment is returned, along with all interest payments. Many like the idea of “getting their invested money back” and are willing to accept a lower interest rate than is available in the market.
That’s why we generally prefer clients invest in individual Bonds. In certain instances, we utilize a ” laddering ” strategy, which means that you buy a series of different bonds with varying maturities. With a laddered strategy, you can invest the bond proceeds from maturities into bonds at longer maturities offered at higher interest rates.
In certain situations, you might end up getting a false sense of security from owning individual bonds:
- If you need to sell before the bond matures, you could face a loss in that scenario.
- As a small investor, it can be difficult to amass a sufficiently diversified portfolio with exposure to different parts of the bond market, credit qualities, and maturities.
- Another issue is transparency. The research required for your due diligence on individual credits can be challenging.
- And then the other drawback is bid-ask spreads for smaller investors. You can get gouged by trading costs because you’re investing side-by-side with huge institutional money managers who can obtain much better pricing on their bonds.
Suppose you are interested in holding individual bonds, but have under $200,000 to invest. You could safely consider AAA-rated corporate bonds, certainly Treasury bonds, where you’re less worried about needing to do the research. But anything broader than that, anytime you’re venturing beyond those very high-quality credits, you’re probably better off in a bond fund.
It’s important to keep bond-fund expenses really, really low. Bond funds can be a terrific value in obtaining built-in diversification and professional management. You must make sure that your costs are as low as possible, improving your take-home yield and your total take-home return.