Bonds have done well in an environment marked by high demand, low interest rates and low levels of defaults, but we know that markets change. Investors may not always have such a strong demand for bonds; interest rates may rise, and defaults may also increase.
Given the potential headwinds facing bonds, we believe investors may be better off in bond funds than in individual bonds.
Here are five reasons why:
Creating a truly diversified mix of individual bonds requires a portfolio upwards of $1 million, but investors can buy a diversified portfolio of bond funds for a few thousand dollars. Since bond fund holdings are spread out over many individual issues, they also have less credit (default) risk. Investors who hold individual bonds often have less than ten bonds in their portfolio. This may not be very risky when defaults are few and far between, but if the economy falters and more companies start to default on their debt, there could be greater danger in a homemade portfolio of individual bonds.
2. Expert Research
Most investors don’t check on companies’ financial health before buying their bonds. Instead they turn to rating agencies and simply buy a bond rated Aaa by Moody or AAA by Standard and Poor’s. But these ratings may not always be reliable, as the debt crisis of 2008 made painfully apparent. Mutual fund managers research companies before they buy their bonds. This is particularly valuable when dealing with lower-quality bonds issued by smaller companies. Often companies don’t pay to have the ratings agencies evaluate their debt, so fund managers turn to their own team of analysts to evaluate risk.
3. Tracking Performance
Assessing the returns of a group of individual bonds can be difficult, because the income is not reinvested and some bond issues may not be readily priced. With bond funds, performance is easy to track, and investors may be more likely to pay attention to total return on their bond fund and ETF holdings and more likely to notice when part of their portfolio isn’t working.
4. Access to Different Areas of the Bond Market
Investors who hold individual bonds don’t usually have access to areas of the bond market that may become increasingly important sources of returns, such as high yield corporate bonds, and global bonds, particularly those of emerging market governments. Bank loans are another type of security best accessed through mutual funds. Floating-rate funds are pools of bank loans made to companies, and the interest rates on those loans adjust as interest rates change. This can make them potentially appealing in a rising interest-rate environment.
Perhaps the most important advantage of bond funds versus individual issues is liquidity – the ability to exit a particular asset quickly and efficiently. If volatility increases and all areas of the bond market start to decline, bond fund investors can go to cash and make falling bond prices the fund manager’s problem. It’s much easier to sell shares of a bond fund than to unwind a portfolio of individual bonds. After all, a mutual fund is always required to buy back your shares – but no one is required to buy back your individual bond.