In our current interest-rate environment and with the state of the global economy, retirees looking for income-driven investment vehicles can be hard-pressed to find investments that offer decent yields or dividends. While many vehicles can generate income — including annuities, dividend-paying stocks, real-estate investment trusts, certificates of deposit and others — let’s compare the two major options in the traditional fixed-income space: bonds and bond funds.
Just as a stock mutual fund is made up of thousands of different stocks, a bond fund is made up of numerous individual bonds. This can help an unsophisticated investor achieve diversification at an affordable cost. But what if you’re a sophisticated investor? What if you want to buy a collection of individual bonds yourself as a way to exert more control, eliminate management fees and still achieve diversification? Here are some pros and cons to think about for each option.
Bond funds
On the plus side, bond funds are much more easily accessible than individual bonds, and because they provide ample diversification, they limit default risk for the investor. If one bond inside of a bond fund defaults, the investor may not even notice a significant difference in the broader fund because the holdings inside the fund are so spread out.
Among potential minuses, bond funds certainly carry interest rate risk, which is the risk that the bond’s price will fluctuate as interest rates fluctuate. This could be a good or a bad thing, but in the current environment, with the expectation of rising interest rates, that may not be a great thing for the net asset value, or overall price, of certain bond funds.
However, as rates increase, the bond fund could capture some of that increase in its yield. So, in some years when interest rates go up and bond prices go down, the increase in yield may be enough to offset the drop in price. However, that is less likely to happen if there is a sharp change in rates.
Individual bonds
Individual bonds offer a few key differences from bond funds that could make them attractive to investors. Most importantly, an individual bond has a maturity date, at which time the principal is returned to the owner of the bond. So, while the individual bonds will also fluctuate in price along the way, if the bond owner simply holds the bond until its maturity date, the changes in interest rates shouldn’t have a major impact in the overall performance of the portfolio.
An increase in rates would adversely affect the bond owner only if the owner needed to liquidate the bonds before the maturity date and the bonds were priced below the principal amount. This could be a major “selling point” for the use of individual bonds in our current environment.
Another advantage of investing in individual bonds is that it can make it easier to plan for retirement because individual bond portfolios will have a “yield to maturity” or “yield to worst” that can be calculated from day 1. Yield to maturity, of course, is the yield if all bonds are held to maturity. Yield to worst is what the yield would be if all callable bonds were called at the earliest available time. Of course, this is assuming that none of the bonds default. Some investors may like knowing what to expect from their bond portfolio upfront as opposed to riding it out with bond funds. Plus, that projected yield could be higher than the current yield of a comparable bond fund, partly because there is no operating expense for an individual bond portfolio like there is for a bond fund.
So why won’t everyone start to flock toward using individual bonds?
First, some advisors would say that the use of individual bonds is not possible without at least $250,000 because it is impossible to achieve diversification and favorable pricing with a smaller amount. It is very common to see individual bond purchases available only in increments of $5,000 or $10,000, so without at least $250,000 you would not be able to purchase enough bonds to provide ample diversification. This “unwritten minimum” may eliminate this strategy for many investors.
Secondly, while individual bonds limit interest rate risk, it could be argued that they would increase default risk. With only 20 to 40 individual bonds in a portfolio, the impact of one of them defaulting would be much more significant than a bond defaulting inside of a bond fund, because bond funds can hold several hundred individual bonds. If this is a concern for individual bond investors, then I would suggest investing only in bonds that carry high credit quality, although this doesn’t guarantee safety from default.
Many factors leading the bond defaults are unforeseen and out of the control of the investor. However, the default rates on investment-grade bonds are typically extremely low, usually under 1%, according to Standard & Poor’s One-Year Global Corporate Default Rates By Refined Rating Category, 1981-2008.
Consider all options
Like every other type of investment, individual bonds and bond funds both have their pros and cons. This is certainly not an in-depth analysis of each strategy, but just a couple of things to think about if you’ve been considering the use of individual bonds or need income in retirement. With interest rates potentially on the move upward, it might be a good time to consider not only these two options, but all alternatives that can help generate income for retirement.
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