A debate has been picking up steam in our industry between individual bonds and bond mutual funds ever since interest rates jumped substantially in April and May of 2013. During that period, the 10-year Treasury bond yield jumped nearly 1.00%, which was one of the biggest increases in years. It caused bond values to drop, causing bonds to suffer a rare down year. As a consequence, it prompted many investors to look more closely at their bond holdings to see if they were exposed to further interest rate risk.

That bond review continues even today despite the fact that interest rates actually declined since the end of 2013. Regardless, investors believe interest rates are ready to climb because the Federal Reserve may finally begin lifting short-term interest rates as early as this December based on recent comments from Janet Yellen. Therefore, if interest rates are going to begin moving higher, the question is, is it better to use individual bonds or bond mutual funds in your portfolio?

First and foremost, we’ve always viewed bonds as volatility reducers, and not as income producers, and understanding the role they play is very important. Many investors view bonds as income generators and reach for the highest yields possible. This has been a good strategy when interest rates are low, but can be problematic as interest rates rise.

Remember, bonds gain value when prevailing interest rates fall, while losing value when prevailing interest rates rise. There are reasons this relationship happens, but the main point is, you must understand the inverse relationship of interest rates and bond values in order to construct an appropriate bond allocation.

This leads us back to my original question: does it make sense to own individual bonds or bond mutual funds for the fixed income portion of one’s portfolio?

Individual Bonds

You can purchase a variety of individual bonds ranging from government bonds to corporate bonds, including varying types of credit quality, maturities, and yields. One of the big myths about owning individual bonds is that you don’t have to worry about losing money, or having the bonds depreciate. Just because you own an individual bond and plan to hold it until maturity does not mean that its value doesn’t fluctuate. All bonds move in response to daily changes in interest rates, credit conditions, and a host of other variables. What happens if prevailing interest rates are increasing and you need to take a withdrawal from your portfolio, and you do not want to sell stocks/stock funds in order to do so? You would have to have to sell some individual bonds at a possible loss to do so.

Owning individual bonds doesn’t mean you have adequate diversification. Treasury bonds offer very low yields and will never default. Hence, there is no credit risk. However, if you want higher yields, then you may have to purchase corporate bonds, or tax-free municipal bonds. Tax-free municipal bonds have some risk associated to them as we have seen with the City of Detroit and Puerto Rico more recently but are generally more appropriate for higher income individuals. The municipalities mentioned had to make substantial financial changes and bond holders lost value. The main point is, be careful with bonds that have higher yields because they come with greater risks. Diversification is just as important with tax-free muni bonds as with any other bond type.

Therefore, the key question is, do you have adequate diversification for this basket of your portfolio? Or more simply, can you obtain sufficient fixed income diversification owning individual bonds?

A final and important point about individual bonds: volatility can be very dramatic as well. On a really bad day, a 15-year Treasury bond could actually drop in value by a couple of percentage points. As I will discuss below shortly, bond mutual funds, because of their vastly superior diversification, would experience less interest rate fluctuation volatility.

The Case for Owning Bond Mutual Funds

As a firm, we like using high quality, low-cost bond mutual funds instead of individual bonds because aside from owning hundreds of bonds for diversification, you can benefit from the following:

Professional Management

You can gain access to some of the best fixed income managers available at reasonable costs. These professionals spend their entire day figuring out what the best bonds are based upon many parameters.

Wider Investment Universe

Most bond mutual funds can own bonds of different maturities, credit qualities, and sectors, hence their diversification benefits. Managers are in a good position to evaluate all parts of sectors, and qualities to make the appropriate purchase and/or sale decisions. Because bond funds can own literally hundreds of bonds of various characteristics, volatility may be more suppressed compared to owning a few individual bonds.
As an example, if bond fund managers believe interest rates are going to rise, they can make adjustments to help protect shareholder capital from declines.

Portfolio Rebalancing

It is far easier to rebalance your portfolio and manage your investment allocation when using no-load bond mutual funds since you can sell a portion of mutual funds. It would be more challenging doing so using individual bonds because of the costs involved trading bonds. The costs of trading bonds, as a recent article in the Wall Street Journal indicated, can be difficult. The mark-up that brokerages charge can be large so if you are purchasing smaller amounts of bonds, it can result in sizeable costs. Individual bonds tend to be more cost efficient at amounts of $100,000 or more per bond. Most individual investors do not have a portfolio large enough to take advantage of buys at that level.

I’m not saying that owning individual bonds is necessarily a bad strategy. But I’ve always believed that diversification is important, and having a professional build a portfolio of bonds to reflect current market dynamics is so very important in today’s environment. That’s why I like the advantages and flexibility mutual funds offer for this portion of your portfolio. We know mutual funds have costs involved so finding a bond fund with low expenses only enhances their appeal. While it may look slightly cheaper to own individual bonds on the surface, this isn’t necessarily the case, since investors still have to pay trading commissions and often get less favorable pricing than institutional investors. As a result, I believe the advantages of using mutual funds for the bond portion of your portfolio outweigh the apparent advantages of using individual bonds.

Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Investing involves risk and investors may incur a profit or a loss. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making an investment. Please consult with your financial advisor about your individual situation.

Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation.