Stock markets tend to be pretty good at keeping investors up at night. Peaks, troughs, business cycles, corrections, and crashes are par for the course when investing in stocks. And for many investors this is just a little too much excitement.
For anyone uncomfortable with the risk of investing in stocks, bonds are often the first alternative. They won’t nock knock your socks off with huge returns, but bonds can provide steady income with less risk that your portfolio sours.
But when it comes to buying bonds, investors have a big choice to make: do you buy individual bonds or bond funds.
Unlike stocks, the choice between buying individual securities or a fund that includes individual securities has major implications.
Here’s a quick guide that explains what you need to know.
Buying Bonds
When you’re buying bonds, you’ll always need to go through a broker. And unfortunately, bonds don’t have big, efficient, centralized marketplaces like stocks do.
This means you’ll need to pick up the phone and call someone at your favorite brokerage firm. If that firm happens to hold the bond you want in their inventory, you might have just found a new addition to your portfolio.
Unless you’re buying U.S. government bonds, there’s a strong chance your broker won’t have exactly what you’re looking for. They might have something similar that they can offer you, but chances are they won’t hold the exact security you want.
After the financial crisis in 2008, banks across the board have been forced to boost their liquidity reserves. In order to comply with the heightened rules, many of them had to cut back on their less profitable businesses.
In other words, they had to hold more cash and make cuts to certain business lines. Coincidentally, bond trading was one of the casualties. So, today brokerage firms have much smaller inventories of bonds ready to sell you than they once did.
That means it’s likely that your brokerage firm won’t have the exact security you’re looking for. They’ll probably have to call around to other firms to find it.
If they can find the bond you want, they’ll offer it to you at a marked up price. As you can guess, the bond will be slightly more expensive since your brokerage firm acts as the middleman.
Bond Funds
Buying bond funds is a much different experience.
Most bond funds are either mutual funds or exchange traded funds (ETFs). Mutual funds can be purchased directly from mutual fund companies, or through your brokerage firm. ETFs (as their name suggests) can be bought through your broker over an exchange, just like stocks.
Like funds of any other asset class, bond funds pool together investor money to buy a group of different bonds. When you buy a share of the fund, you own a piece of each bond held by the fund.
The advantage of bond funds is also the same as other asset classes: instant diversification. When buying a fund, you aren’t as exposed to any single security. If you own a bond issued by a company that goes bankrupt, you might lose your entire investment.
If you bought a fund that includes the same bond, it’d constitute a far smaller percentage of your investment. Your potential loss would be far smaller if the bond defaults. By owning funds, you’re spreading out the risk that a single security runs into trouble or defaults.
Diversification isn’t free though. Most all funds have some type of operating expense, which is normally expressed as an annual expense ratio.
Expense ratios range from under 0.25% all the way up to over 2%, and are netted against the fund’s returns. If you’re invested in a fund that has a 5% return one year and an expense ratio of 1%, you’ll only see a 4% return in your account.
Duration
Let’s imagine that you decide to buy an individual bond, not a bond fund.
After you buy the bond, you’ll collect principal and/or interest payments until the bond matures. Usually interest is paid every 6 months, but bonds come in all shapes and sizes. Then when the bond matures, you’ll receive the face amount of the loan.
For fixed rate bonds that pay a steady amount of interest, the price of the bond will fluctuate based on interest rates in the market.
This concept can be a bit confusing, so here’s an example:
Say you buy your bond for $1,000 and it pays you 4% interest per year. You’ll receive $20 in interest every six months. Then when the bond matures (let’s say in five years) you get the principal of $1,000 back.
What happens if interest rates change? Let’s say that two months after you buy the bond, interest rates in the market for the exact same bond fall to 3% per year.
This means that investors buying the very same bond for $1,000 will only get 3% interest, or $15 every six months. Your bond will continue to pay 4% interest until it matures. Your bond looks mighty attractive now that interest rates have dropped. It also means it’s worth more and its market price will rise.
The opposite is also true. If instead rates went up to 5%, your bond at 4% wouldn’t look quite as good. If investors can buy $1,000 bonds for 5% interest, they won’t be willing to pay as much for yours. The market price of your bond will fall.
This concept is known as duration, or interest rate risk. Technically duration is the magnitude of change in a bond market’s value, given a 1% change in interest rates.
When you hear figureheads in the financial news talk about duration risk or interest rate risk, this is what they’re talking about. If you own a bonds and interest rates rise, the value of your holdings will fall.
Buying Bonds vs. Buying Bond Funds
In addition to the cost and diversification differences, duration is a very important concept when comparing bonds to bond funds.
If you were to buy one individual bond, as in our example above, you would have a specific amount of duration risk. If interest rates rise, your investment won’t be worth as much.
Remember though – regardless of how much your bond is worth in the marketplace, you’re still due your principal investment back at maturity. In our example, that’s your initial $1,000 investment in 5 years.
Even though the market value of your bond may fall, you won’t realize that loss unless you sell the bond for less than what it’s worth. You’ll still receive $20 every six months and $1,000 in 5 years.
Bond Fund Duration
Bond funds are set up differently. Bond funds tend to mix together many different bonds that all have different maturity dates. A typical fund contains bonds that mature over different time frames. The fund might have bonds that mature later this year, in 3 years, in 5 years, and so on.
Each time a bond matures, the fund has cash to reinvest. It’s the fund manager’s job to take that cash and buy another bond that’s suitable for the fund.
This is known as “rolling the bond over.”
It also means that the duration of a bond fund is very different from the duration of an individual bond.
Bond funds constantly have individual securities maturing and cash to reinvest. It’s an ongoing cycle that continues in perpetuity. There’s no end date. If you invested $1,000 in a bond fund, the only way to get your money back is to sell the fund at the prevailing market value.
Remember – when buying individual bonds, you won’t be forced to take a loss. If interest rates rise and your bond loses value, you can always just hold the bond until maturity and collect the principal.
In a bond fund, there is no maturity date. To get your principal back you’ll need to sell the fund.
An Alternative
There are a few funds on the market that hold bonds with consistent maturities, like Guggenheim’s Bulletshares. These funds return money to shareholders once the fund’s holdings mature.
This is the exception though. Nearly all bond funds on the market today have varying maturities that are perpetually rolled over.
Which Is Better?
There are pros and cons to both options.
For most investors bond funds will be the best choice. They be slightly more expensive after including expense ratios, but diversification is always important.
Buying bonds should be left for more experienced investors who don’t mind talking to traders at a brokerage firm. You won’t get the same diversification as you will from a fund, but you have ultimate control over maturity and duration risk.
When you’re saving for a specific event, it can be very convenient to have control over the duration of your bond portfolio.
For example, say you’re saving for your kid’s college education in three years. You could buy four bonds, with maturity dates that match the tuition payments. You could buy one bond that matures in time to pay freshman year’s tuition, another for sophom*ore year’s tuition, and two others for junior and senior year. A bond fund is easier to buy and is more diversified, but you’ll need to liquidate it in the market to get your money back.
The key is to understand exactly what you’re investing for, and build a portfolio accordingly.
