Individual bonds: The answer for rising rates?

Individual bonds can be held to maturity but have a few key drawbacks, too.

Morningstar 14 December, 2015 | 6:00PM
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Question: Can I just buy individual bonds and hold them to maturity, and not worry about rising rates?

Answer: The short answer is yes, you can. But there could be drawbacks to doing so.

As you allude to in your question, buying an individual bond gives you a fixed rate of return, or yield, and if you hold the bond until maturity (provided you buy a bond that does not default), you will receive your interest and principal regardless of interest-rate fluctuations.

Bond-fundholders, by contrast, won't necessarily be assured that their principal value won't decline, and the interest they receive from their bond funds could also fluctuate. The crucial difference is that the bond-fund manager, like a stock-fund manager, is overseeing a basket of securities whose value must be tallied each day; that value depends on the price of each of the securities in the portfolio at the end of that day. That means that the value of the portfolio could change even if the manager doesn't do a thing.

In a period of rising interest rates, which tends to make already-existing bonds with lower coupons less valuable than the new bonds with higher rates, bond-fundholders can see a reduction in their principal values. (The upside, however, is that sometimes the manager is able to partially offset some of those price declines by swapping into higher-yielding bonds.) Thus, a crucial difference between a bond fund versus an individual bond held until maturity is that, with bond funds, there's a greater chance that your principal value when you sell will be different--for better or for worse--than the amount you put into the bond fund in the first place.

Given their historical low levels, interest rates have a lot more room to go up than they can go down at this point. There's an increased chance that the bonds in a bond portfolio will decline in value over the time that you own a fund. Individual bondholders won't have to contend with that same issue. If they invest $10,000 in a bond and the issuer makes good on its debt, the amount they put in is the amount they get back.

At the same time, it's unwise to derive a false sense of security from investing in individual bonds. Even if individual-bond buyers are able to circumvent interest-rate risk by holding individual bonds until maturity, they may court risk on other fronts. Here are some of the key ones to bear in mind.

Research challenges

You often hear professional management touted as a key virtue of mutual funds, and this is arguably even more important in the realm of bonds than it is for stocks. That's because, in addition to evaluating bonds' interest-rate sensitivities, bond-fund managers also spend time evaluating bond issuers' creditworthiness as well as other features of the bond. How healthy is the company and, in turn, how likely is it to make good on its debts? And if a company's financial health isn't completely A-OK, how much extra yield should you receive as compensation for taking the extra risk of buying its bonds?

Most top bond managers don't just take the rating agencies' word on whether an issuer is creditworthy or not; instead, they roll up their sleeves and assess companies' financial health on their own. Most brokerage platforms also provide basic comparative information about bonds, including maturity and credit-quality information.

All the same, individual-bond buyers may have difficulty finding reliable independent information about less-liquid bond issues from smaller entities and municipalities, and they may also have trouble evaluating the features that are specific to that particular bond, such as whether it's callable and how much extra income they should receive if it is. And even if they're sticking with more-liquid bond types, they may not have the time or inclination to conduct the research they need to assemble a well-diversified, high-quality portfolio.

Lack of diversification

Another hurdle individual-bond buyers face that fundholders do not is the difficulty of building a well-diversified portfolio without a whole lot of money. Bonds are typically issued with face values of $1,000, but you may need to buy a block of several bonds to obtain decent pricing. To assemble an individual-bond portfolio that's reasonably diversified across market sectors, you would need to have a pretty good chunk of change; $100,000 is often bandied about as the minimum threshold for a portfolio of individual bonds to make sense over a bond fund. By contrast, bond-fund investors assemble a very broadly diversified portfolio of bonds for a low cost--corporate bonds, government bonds, asset-backed bonds--thereby reducing the damage that any one holding can inflict on their overall portfolios.

Trading costs

In a related vein, individual-bond buyers, particularly those without a lot of money to invest, can face high trading costs when transacting in individual bonds; even investors who are buying many thousands of dollars' worth of bonds may face much higher bid-ask spreads than institutional buyers who are trading millions might pay. Those high bid-ask spreads occur when a bond buyer purchases a bond that's already trading on the market; as compensation for facilitating the trade, the broker/dealer will mark up the bond's price above where it's currently trading and will purchase it back at a price below its current value. These bid-ask spreads will tend to be higher for smaller investors than for larger ones and can, therefore, eat into the smaller bond investor's take-home yield and total returns. Thus, even though the mutual fund manager levies a management fee, the manager may be able to make up that amount by swinging more favourable trading costs. (Earlier this year, Canadian regulators announced they would be looking into pricing transparency in the bond market.)

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