While individual investors may not necessarily view the building of a portfolio of securities as akin to going to war, it can nonetheless pose a considerable challenge. One of the basic decisions one faces when building and managing a bond investment portfolio, or stock portfolio for that matter, is whether an active or a more passive strategy will be employed. With both schools of thought having its own sets of pros and cons, how you invest comes down to a matter of personal preference.
The more simple approach to investing is the passive approach. When it comes to bonds, this could mean turning your money over to a professional, hopefully competent manager, and investing in bond funds, preferably ETFs and CEFs that tend to offer more bang for the buck as compared to traditional open-ended funds. Or it could mean investing in individual bonds through the confines of a bond ladder. Bond ladders are structured so that the investor has pieces of paper maturing on a consistent basis. When one bond matures, another bond is simultaneously invested in, usually with a lengthy maturity. This achieves a blending of maturity and, depending on the scope of the ladder, an intermediate-term yield.
More active bond investors may also utilize funds, but there is less of an agnostic viewpoint towards interest rates, bond maturities, and credit analysis. An “activist” will likely buy and sell more frequently, whether funds or individual bonds, taking the time to sell securities that have appreciated by means of a credit upgrade, or because rates have eased. There is usually an inclination to generate a modest level of capital gain in addition to the passive coupon that is being generated by the bond.
For some, the decision on how to invest in bonds may be a rather simple one. Those with little time on their hands or little inclination to think about corporate credit or the general macroeconomic environment would be better served investing in a passive manner. And though I am a constant advocate for the use of individual bonds and ladders when investing in investment-grade type situations (government securities, high credit corporates, insured municipals), this may not be possible (or suitable) for all investors. So if funds are going to be used, in the course of due diligence one should consider, minimally, the following:
- What is the fund investing in?
- What is the fund’s expense ratio (annual cost to own it)?
- What is the fund’s track record?
- Who is managing the fund?
- What is the blended maturity of the fund’s holdings?
Once a fund(s) is selected, the hope is that it will be a “set it and forget it” undertaking. One must remember when investing in funds that capital, unlike when investing in individual issues, is at risk. Depending on the performance of the portfolio and the movement of interest rates during the span you hold the fund, you may experience a gain or loss of your money. When you invest passively in individual bonds or a bond ladder, you have the security of knowing that your capital will be returned to you if you are able to hold the issue to stated maturity.
A more active bond investor might be considered more of a gambler, willing to make some tactical decisions in order to achieve a better rate of return as compared to our more passive investor. This might mean investing in lower rated bonds when the credit cycle seems favorable, lengthening or shortening maturities in response to near-term interest rate movement, or utilizing levered ETFs to exponentially profit (or potentially lose) from a near-term call.
Though there is certainly no right or wrong way to invest in bonds, the pros and cons of passivity versus activity should be weighed before engaging the space. More passive investors should enjoy the predictability of returns that ladders and funds may be able to provide, while more active investors might be able to generate additional returns by tactically adjusting a portfolio as market and macroeconomic conditions dictate.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.