For most investors, bonds are supposed to play a comforting role: dampening volatility and providing a bit of income in your portfolio.
Yet bond prices have slumped this year and volatility has increased, making bonds a potentially troublesome investment.
That makes it a good time to review your bond holdings. As part of that review, you may also want to ask a basic question: Should you invest in individual bonds or bond funds?
Bond funds offer several advantages and are a good choice for most investors, financial advisers say. Funds provide instant diversification and expertise in tricky parts of the market, including high-yield and foreign bonds.
But advisers say individual bonds can also be a good fit for some people — if you’re willing to do the homework.
Here are the pros and cons of each approach and some strategies to consider for today’s challenging bond market.
Bond buying 101
Buying bonds individually can make sense if you need a predictable income stream and some assurance that your principal will be returned.
If you own a basket of high-quality bonds, you can be reasonably certain you’ll receive interest payments on a regular basis, typically twice a year. Rising interest rates may pressure the market prices of your bonds. But they won’t impact your annual income, notes James Bryan, Jr., director of fixed income at South Texas Money Management, in San Antonio, Texas.
Plus, you’re highly likely to get your principal returned when a bond matures if you stick with debt issued by businesses with top credit ratings — companies like General Electric (GE), Wal-Mart (WMT) and IBM (IBM).
Buying your own bonds can be inexpensive. You won’t pay annual management fees since you are your own portfolio manager, and transaction costs, if any, can be quite low.
You can buy Treasury bonds and T-bills for no transaction fee at Treasurydirect.gov and most brokerage sites. On Fidelity’s online platform, a $1,000 corporate bond costs $1 to buy or sell (with an $8 minimum). Discount brokers such as Schwab charge similar commissions to trade corporate bonds online.
Keep in mind that there are some embedded costs in buying your own bonds. The price of the bond may be marked up by the broker, reducing the bond’s effective yield. If you want to sell the bond before it matures, you may not get the best price, especially if demand for the bond is weak.
Building a bond ladder
For clients who want individual bonds, many advisers recommend building a “bond ladder.”
Say you have $50,000 to invest. You could put $10,000 into five different bonds maturing every two years. For example, one bond could mature in two years, another in four years, six, eight and 10 years. Along the way, the yield of each bond would increase, since longer-term bonds typically offer higher interest rates than short-term bonds.
When the first bond matures in two years, you would reinvest the money in a new 10-year bond since, after two years, that 10-year bond would now have a maturity of eight years. In another two years, you would do the same thing.
Each time, you’ll wind up swapping a low-yielding, short-term bond for a higher-yielding, longer-term bond. And in most market environments, you should be able to maintain a steady yield for the overall portfolio, says John Gerard Lewis, president of Gerard Wealth Management, in Olathe, Kan., who uses bond ladders for his clients.
While you can incorporate any type of bond into a ladder, Lewis recommends sticking with Treasury notes and high-quality corporate bonds. And you should stick with bonds maturing in up to 10 years since they’re less sensitive to interest rates than longer-term bonds. (Bond prices and yields move in opposite directions).
Know the risks
If you’re going to pick your own bonds, most advisers suggest investing at least $50,000 to $100,000 to build a fully diversified portfolio. And you should be familiar with two key types of risk: credit risk and interest-rate risk.
Credit risk refers to the chance the bond issuer will default, by missing an interest payment, for example — or get its credit rating cut. Corporate and municipal bonds all have credit risk, and their yields reflect those risks, with higher-rated bonds yielding less.
U.S. Treasury debt doesn’t have credit risk since the U.S. government isn’t considered a default risk.
Interest-rate risk, by contrast, affects virtually all bonds. Because bonds have a fixed coupon — the amount of interest they’re obligated to pay each year — rising rates make them less valuable than new bonds issued at higher rates. That dynamic is what pushes bond prices down and yields up — and it’s largely responsible for the market’s current downturn.
A standard way to gauge interest-rate risk is by looking at a bond’s “duration.” For example, a bond with a duration of five years will lose about 5% in price if interest rates rise one percentage point. You can find a bond’s duration on Morningstar.com, Fidelity.com and other financial sites.
Another feature to bear in mind is whether a bond is “callable.” Some corporate bonds can be called, or redeemed, by their issuer before the maturity date.
In a falling interest rate climate, issuers may call bonds to refinance at lower rates. That can hurt your returns because you’ll need to reinvest the money at a lower rate. And you may lose money on the bond if you bought it above 100 cents on the dollar, or “par” value, and the bond is redeemed at par.
When screening for bonds you can exclude callable bonds or only buy bonds with call protection, which can make up for losses if the bond is called. Bonds can also be redeemed before their maturity for other reasons; you should consult an adviser to fully understand these provisions.
The benefits of bond funds
One big advantage of funds is instant diversification. Bond funds typically hold hundreds of bonds across different sectors and maturities. Another advantage is minimum investments as low as $2,500. And bond funds can easily be bought or sold anytime — which is not always the case with individual bonds.
You’ll also get professional management. Portfolio managers and analysts scour the market for the best values. Using their clout and buying in bulk, bond fund traders can often get better prices than individual investors, says Mark Sommer, a Fidelity Investments fixed-income manager.
Further, a skilled manager can help navigate a tricky market. That could be especially valuable in today’s climate, where falling rates are pressuring many types of bonds.
Managers can take steps to reduce interest-rate risk, notes the Kansas adviser Lewis. And they can invest strategically, potentially boosting returns over their benchmark index.
For parts of the market that require complex analysis, active managers can also be highly valuable.
“The more complex the area of the market, the more value a manager is going to add,” says David Twibell, president of Custom Portfolio Group, in Englewood, Colo., who recommends funds for areas such as foreign bonds, junk bonds and convertible securities.
Fees and other drawbacks
While bonds provide fixed interest payments and the return of your principal, funds don’t offer that security. A fund’s share price and yield can bounce around quite a bit. And you may lose money when you sell the fund.
Another potential drawback is that funds may have to sell bonds to meet shareholder redemptions, says Bryan, the Texas adviser. Most funds manage that process quite well. But some funds have been forced to sell bonds in a weak market this year, hurting shareholders’ returns.
Fees are another factor. The average annual expense ratio for bond funds is 0.61%, according to the Investment Company Institute. If a fund is beating its benchmark, those fees may be well worth it. Otherwise, it may pay to look for lower-cost options.
There are plenty of inexpensive bond ETFs and funds on the market. For example, the iShares Core Total U.S. Bond Market ETF (AGG) tracks an index of the broad U.S. bond market and has an expense ratio of just 0.08% or $8 per $10,000 invested.
In the fund space, some top-performing intermediate-term funds, according to Morningstar, include DoubleLine Total Return Bond Fund (DLTNX), Metropolitan West Intermediate Bond Fund (MWIMX) and Fidelity Total Bond Fund (FTBFX).
The hybrid approach
Ultimately, how you invest depends on your time horizon, income needs and appetite for do-it-yourself investing.
For investors who want a steady and predictable income stream, individual bonds may be a better choice, says Bryan. For investors who can handle a bit of volatility and are daunted by picking their own bonds, funds can make sense.
The Colorado adviser Twibell uses a mix: He buys high-quality corporate bonds for the core of a client’s portfolio, and he supplements it with funds holding high-yield and international bonds — areas where he feels fund managers can make the biggest difference.
However you go, most advisers say bonds should still play a role in your portfolio. It’s just a matter of picking the right mix to suit your needs.
Steve Garmhausen is a contributing writer with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.