Many investors buy individual bonds rather than putting their money into bond funds. For now, those investors are crowing about the steady income they’re earning. They’ll continue to get those payouts, they say, regardless of what foolishness erupts in the bond market. And as long as they hold their bonds to maturity, they’ll get their entire principal back -- except in the unlikely event that a bond issuer defaults.
But with yields microscopic, owning individual bonds is the wrong thing to do now. Why? Because bond yields will rise -- probably dramatically -- when the Federal Reserve begins backing away from the easy-money policy that has driven interest rates down to record lows. That will pummel bondholders because yields and prices move in opposite directions.
It’s true that holders of individual bonds will continue to collect their coupons. But when yields rise, inflation normally does, too. An investor who purchased 10-year Treasury bonds in 1977, when they yielded 7.5 percent, lost 6 percent after inflation in 1980 -- a year the consumer price index rose 13.5 percent.
Given that most bond funds are likely to lose value when rates start to rise, why is a fund any better?
First, you can sell a fund at net asset value five days a week. Try selling a handful of individual bonds on your own. Almost invariably, you’ll be offered 3 percent to 5 percent less than the bonds are worth because no professional wants to buy the relatively small bond pieces that individual investors own.
Second, fund managers can use derivatives to adjust the sensitivity of their bond funds to changes in yields. One of my favorite funds, Metropolitan West Unconstrained Bond M (symbol MWCRX), should lose little or nothing when rates rise because it’s deploying some of its assets to sell Treasuries short -- that is, betting that they will fall in price. (The fund is a member of the Kiplinger 25.)
Third, a bond fund can take risks that would be imprudent for an individual investor. If you own five or 10 individual bonds, you can’t afford for even one of them to go bust, so you have to stick to the highest-quality issues. But if you’re a fund manager and you own hundreds of issues, it’s reasonable to take some risks with at least a portion of them in return for higher yields.
Fourth, fund managers have at their disposal analysts who are much better equipped to dissect an individual bond than you are.
Fifth, whatever value is left in the bond market today can be found only in debt that few individuals are capable of analyzing on their own: high-yielding junk bonds, emerging-markets bonds and some mortgage securities. If you want to own those, you’ll need diversification and, yes, professional management.
Steven Goldberg is an investment adviser in the Washington, D.C. area. Send your questions and comments to
moneypower@kiplinger.com. For more on this and similar money topics, visit
tulsaworld.com/kiplinger.
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