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Why Individual Bonds and Bond Funds May Have a Place in Your Portfolio

Fall 2013 Edition

As a general rule, as interest rates rise, bond prices fall. If prices fall by more than the coupon payments of the bond, total return becomes negative. 

It’s important to understand the fundamental differences between an individual bond and a bond fund. Individual bonds, if held to maturity, generally do not experience the same losses as bond funds when interest rates rise. Instead, high-quality individual bonds may deliver the scheduled cash flows from the coupons and return principal upon maturity. In contrast, bond funds are generally not mandated to hold bonds to maturity, so if interest rates rise, total return is unpredictable.

For the past few decades, falling interest rates have masked an inherent weakness of bond funds when rates rise. The last few months provided a sneak preview of the challenges faced by bond fund investors in periods of rising rates. Since early May, the yield for the benchmark 10-year Treasury note has increased by nearly 100 basis points and bonds have lost 2.35% as represented by the Barclays U.S. Aggregate Bond index.

If individual bonds offer greater certainty in times of rising interest rates, why do so many investors continue to flock to bond mutual funds and Exchange Traded Funds (ETFs)? Here are a couple of reasons to help explain this flow into funds.

First, many investors favor the diversification of a fund. If an issuer defaults or fails to make a coupon payment, the effect is usually minimal on a fund’s overall performance. The inherent diversification found in a fund helps smooth out volatility. The last few years have witnessed a wave of defaults by municipal borrowers in a variety of places, ranging from Jefferson County, Alabama to Harrisburg, PA to Stockton, CA (Source: http://libertystreeteconomics.newyorkfed.org/2012/08/the-untold-story-of-municipal-bond-defaults.html). Last month, Fitch Ratings said it expects Detroit will miss payments on its general-obligation bonds that come due on October 1st, resulting in a downgrade to default. Diversification is especially important to holders of high-yield bonds, or bonds with lower credit ratings than investment-grade bonds. These bonds are more susceptible to default so investors generally prefer buying them through a fund. Incidentally, high-yield bonds have been one of the top performing asset classes over the past few years in part because investors have been unable to increase coupon payments by buying bonds of longer duration. In other words, the “yield curve” has been relatively “flat” so one of the only ways investors have found to boost yields has been to take on more credit risk.

Second, investors can more easily access certain types of bonds through funds. For example, investors can easily gain exposure to emerging market debt, developed international debt and foreign Treasury Inflation Protected Securities (TIPS) using ETFs. In fact, recent innovative ETF solutions have come to market that for the first time allow an investor to buy a pool of bonds that mature on a pre-determined date which can avoid interest rate risk in the same manner that an individual bond does if held to maturity. These “target dated” bond ETFs are an exciting new development.

We believe some of our clients can benefit from a strategy that incorporates both individual bonds and funds, especially ETFs. Laddering investment-grade corporate and municipal individual bonds can manage interest rate and reinvestment risk. However, funds can offer greater liquidity, diversification and easier access to foreign debt opportunities than individual bonds. Innovations in product design may lead more investors to new “target dated” bond ETFs which have desired characteristics of both individual bonds and bond funds.