I’ve been reading on the Internet and in financial publications that when interest rates start to climb, investors should dump their mutual funds that own bonds because the funds will decline in value. On the other hand, I heard it made more sense to own individual bonds because they never lose money and you’ll always get your money back at maturity. Which advice should I follow?
This is such a great question! Given that U.S. stock markets have performed so well since the financial crisis, someone asking about bonds is very exciting. In actuality, bonds are about as boring as they get, but a long-term, diversified portfolio would have a difficult time existing without them. That’s because bonds are important diversifiers to stocks. Think of them as “bread and butter.” Butter always tastes better on bread. Translation: Stocks and bonds are a great combination!
I tend to view bonds as the anchor of a portfolio. When stocks are zigging and zagging, bonds tend to hold up reasonably well, even during periods when interest rates are going up. Their volatility reduction is such a huge benefit to owning them, and this often gets lost when the financial media jumps into a topic that confuses investors. Diversification is an important part of investing, and even if you have identified individual bonds you want to own, you still have to own more than one to be diversified. And just because you can own a bond until maturity (say 10 years) you can still experience fluctuation and decline either due to rising interest rates or credit-related problems.
So while owning individual bonds can help take some of the pressure off of rising rates, they become more difficult to manage in a portfolio. As an example, let’s say you have a stated allocation of 60% stocks and 40% bonds in your investment portfolio. If stocks dropped significantly, it could result in the allocation of bonds becoming 50% of the portfolio. As a result, you would have to sell some of your individual bonds to get the portfolio balance back to 60/40.
Unfortunately, it is more challenging to sell partial shares of bonds due to how they trade.
That’s why I recommend bond mutual funds that invest in more than one particular bond versus owning individual bonds. With the mutual funds, a seasoned fund manager can buy and sell shares of the variety of individual bonds in the fund as needed. Doing that yourself for individual bonds you own can be difficult, and you may make bad decisions on which ones to sell, which could ultimately hurt your overall portfolio.
Lastly, a key characteristic of bond mutual funds is the reinvestment of interest income, which is used to purchase more shares and helps offset some of the volatility associated with rising interest rates. If you own or invest in individual bonds, then the interest paid does not get automatically reinvested, it merely sits in cash until you do something with it. Depending on the type of bond fund, reinvesting interest income plays an important role in the fund’s total return over time.
If one was concerned about rising rates, then they could invest in bond funds with shorter average maturities, which are less impacted by rising interest rates than bond funds with longer average maturities. Bond funds do not have definitive maturity dates like individual bonds do, but as you can see, investors can take comfort in the advantages bond mutual funds offer no matter what interest rates do going forward.
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