The pros and cons of investing in bond funds

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Like mutual funds and exchange-traded funds, bonds and bond funds can help investors take the edge off market volatility and create a balanced, diversified portfolio. But a debate rages among people who worry about this stuff: Is it better to own individual bonds or bond funds?

The benefits of bond funds

With an individual bond, you get 100 cents on the dollar when it matures (assuming the issuer doesn’t default). The knock on bond funds is that, because they are constantly buying and selling bonds, they have no maturity date. Therefore if rates are rising, the value of the fund goes down, and you might have to sell the shares for less than you paid.

While this criticism of bond funds is accurate, there are quite a few caveats. For starters, you’ll need at least $500,000 in the bond portion of your portfolio to achieve sufficient diversity and the scale to absorb transaction costs. Short of that, you’re better off in funds.

What’s more, a bond fund can take advantage of rising rates by constantly buying bonds with higher coupons. But say you own a $10,000 bond paying 3% interest and rates rise to 4%. The semi-annual payouts of about $150 won’t be enough to buy a new, higher-yielding bond.

And finally, while it’s true you will get your money back if you hold a bond to maturity, you still suffered opportunity cost – you were unable to invest that $10,000 in a new, higher-paying bond without selling and taking the loss.

Investing passively and actively

For those who decide to buy bond funds, remember the two lodestars of investing: low costs and diversification. To achieve maximum diversity, build a portfolio of both passive index funds and actively managed funds, U.S. and international.

With indexes, go cheap and go big. The Vanguard Total Bond Market (VBMFX) fund is based on the basic benchmark, the Bloomberg Barclays U.S. Aggregate. Because that fund is heavy on U.S. government bonds, you can boost your yield and spread your risk with the Vanguard Intermediate-Term Investment-Grade (VFICX) fund. Add the Vanguard Total International Bond Index (VTIBX) fund and you’ve covered the globe. Those three funds are good core holdings.

One problem with index investing and bonds, however: Most indexes are weighted by the size of the issuer. So that means investors have the most exposure to the entities with the most debt. Not necessarily a great strategy.

When interest rates rise, a good active manager may be able to anticipate the move and protect you from the worst of it. Even within active management, you might want to diversify, say by going with an active fund benchmarked against the Bloomberg Barclays index, such as Pimco Total Return (PTTAX) or the DoubleLine Total Return Bond (DBLTX).

“Unconstrained” bond funds, meanwhile, don’t track the indexes and can outperform if the manager makes the right call. The managers often base their decisions on where they think economic growth and interest rates are heading, and where they spot opportunities for return. That’s great if it works, but there are no guarantees. One good example: BlackRock Strategic Income Opportunities fund (BASIX).

For actively managed international exposure, consider funds such as Templeton Global Bond (TPINX) and T Rowe Price Emerging Markets Bond (PREMX).

The tax-free municipal bond bump

The higher your income, the bigger the advantage of the federal tax-free payouts from municipal bonds issued by cities and other municipalities. The hallmark of municipal bonds is that their interest is federal tax free, and therefore they are particularly popular with high- income investors.

A muni fund makes sense for your taxable accounts (you forfeit the tax advantage if you own munis in a tax-advantaged retirement account). If you live in a high-tax state such as California or New York, consider state-specific funds, which are also exempt from state and city taxes.

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