(Herald Tribune) - Investors interested in bonds face a challenging economic and interest rate environment. Inflation in 2021 is above 6% and both it and real GDP growth are forecast to be around 3% for 2022. These suggest, along with Fed statements, that interest rates now near historic lows will rise. When interest rates rise current holders of individual bonds or bond funds will see losses. For example, investors that bought broad-based bond funds at the beginning of the year have likely seen losses of around 2%.
These realities leave current holders of bonds or bond funds with different challenges. Holders of individual bonds will see a temporary loss of principal until the bonds reach maturity. Unless they must sell before then, they will eventually receive back the full value of their bonds. Holders of bond funds may never be made whole if interest rates don’t fall back, as bond funds generally have no maturity date.
Investors who want to invest now in fixed income securities are faced with these issues and must also decide whether individual bonds or bond funds are best suited to their requirements, and what percentage of a portfolio should now be in bonds?
Unfortunately, there is no “right” answer to the latter question. It’s too dependent on individual circumstances. I’ve seen cases where 0% in bonds was appropriate and others where 70% was. In my view stocks are the investment for growing wealth and bonds for a good night’s sleep. Thus, investors should only keep enough in bonds so they’re comfortable with the rest in stocks. One guideline is to keep enough in bonds to allow paying all bills for two to four years without selling stocks just in case the market declines. Generally, no more than four years because even bear markets recover by then.
As to whether individual bonds or bond funds: For investors with ample capital, I favor individual bonds. This is because some of bonds’ strengths are diluted in bond funds. Even though their values may gyrate, as noted earlier, individual bonds have a date certain by which patient investors knows they will be whole, and they can control those dates.
Again, this isn’t true for bond funds, since these own many bonds with different maturity dates and are constantly trading them, they have no maturity date. Additionally, their value is inversely correlated with interest rates. Thus, if interest rates rise investors may never receive the return of their principal. However, the interest the fund pays will tend to increase as they always have bonds maturing and can reinvest at the higher rates.
There are other tradeoffs between individual bonds and bond funds. For smaller investors, the bond market is less price efficient than the stock market. This means that they will incur higher costs when they buy a bond. Since bond funds buy large numbers of bonds, they have the clout to minimize these costs. While the buyer of individual bonds may pay an upfront cost, there are no costs when the bond matures. On the other hand, the bond fund buyer pays an annual management fee and possibly other fees.
