| Before we can answer the question “should | | | | expense is only 0.20%. |
| you invest in individual bonds or bond | | | | Safety |
| mutualfunds”, we have to first understand the | | | | Many investors are under the impression that |
| purpose of owning bonds in your portfolio. | | | | owning bonds is a risk-less transaction. That is a |
| Noviceinvestors use bonds as an income | | | | myth that results in a false sense of security. The |
| generator, relying on yields to supplement living | | | | fact is that bonds, whether corporate or treasury |
| expensesduring retirement. Institutional investors | | | | respond to daily changes in interest rates as well |
| and competent advisors, on the other hand, | | | | as credit conditions. Individual bond investors might |
| viewbonds as a tool to reduce portfolio volatility. | | | | take comfort in knowing that at the end of the |
| Total return, not just bond yield, is what counts. If | | | | maturity period, their principal will be returned. |
| the purpose of holding bonds is to control portfolio | | | | However, throughout the maturity period, their |
| risk, then owning bond funds, not individual bonds, | | | | principal will fluctuate. As interest rates rise, bond |
| is the appropriate choice. | | | | principal will go down (since the bonds become |
| Individual bond shares are not cheap. A single | | | | less attractive to new investors). If the owner of |
| corporate bond can cost you $10,000 or more. | | | | the individual bond feels compelled to sell their |
| So, if a retiree with a million dollars decides to | | | | position before the maturity date, they may likely |
| allocate 40% of his portfolio to bonds | | | | take a loss during a period of rising interest rates. |
| ($400,000), he would likely have to purchase at | | | | Bond funds are much more liquid. Granted, bond |
| least forty different issues to achieve asomewhat | | | | funds do not have a fixed maturity |
| diversified bond portfolio. The higher costs | | | | (meaningprincipal nor income is guaranteed). But, |
| associated with acquiring individualbond issues may | | | | fund managers are constantly buying and |
| prevent many investors from sufficiently | | | | sellingbonds within the portfolio in order to |
| diversifying among different issues. | | | | maximize interest income and capital gains. |
| In contrast, an initial investment in a bond fund | | | | Additionally, if you only own forty bond issues in |
| might cost only $1,000 to $3,000 depending onif | | | | your portfolio, having one or two of themdefault |
| you purchase it in a retirement account or not. As | | | | can put a serious damper in your day. In contrast, |
| a bond fund holder you can own stakes indozens, | | | | because a bond fund holdshundreds of bond |
| perhaps hundreds, of bonds with one purchase. | | | | issues, if a handful of them default the impact |
| Let’s take for example the Vanguard | | | | might be nonexistent. |
| Short Term Bond Index (VBISX). If you own an | | | | The Benefits of Indexing |
| IRA, you can hold 642 distinct bond positionswith | | | | By now I hope I’ve convinced you that bond |
| a $1,000 investment in the fund—a far cry | | | | funds are more attractive than individual |
| from the 40 issues we purchased in theprevious | | | | bondissues. But, what type of bond fund should |
| example. | | | | you buy? |
| Costs | | | | There is a strong argument in favor of owning |
| While individual bonds do not incur the ongoing | | | | bond index funds instead of actively |
| management and operating expenses of | | | | managedbond funds. In general, bond index funds |
| bondfunds, they do have associated expenses | | | | offer you broad bond market exposure for a |
| including brokerage commissions/fees and bid-ask | | | | fractionof the cost of an active fund. All other |
| spreads) that all investors should consider. | | | | things equal lower expense ratios result in higher |
| Furthermore, retail investors (as most of us | | | | returns for you. Furthermore, with actively |
| are)get less favorable pricing (commissions AND | | | | managed funds, investors assume an additional |
| bid/ask spreads) than institutional investors. | | | | level of risk: manager risk. |
| Thecosts of trading individual bonds are very hard | | | | In conclusion, there are distinct benefits to owning |
| to accurately pin down and commissions arenever | | | | bond funds in lieu of individual bonds. |
| fully disclosed. If ever there was an area for | | | | Despite their ongoing expense, bond funds provide |
| institutional traders to make obscene profitsin the | | | | a better alternative in terms of diversification, |
| markets, it’s the bond market. | | | | liquidity, and the availability of reinvesting dividends. |
| When you purchase a bond fund, you know what | | | | A low cost low cost bond index fund will help you |
| the cost will be: a transaction fee and the | | | | achieve the portfolio risk control you need. |
| expense ratio. There are a handful of low priced | | | | Remember, just as with equity investments, the |
| bond funds available, including the Vanguard | | | | more broadly you diversify, the better results |
| Bond index we discussed above whose annual | | | | you will attain. |