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Kicking the Bond Fund Habit

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bond-portfolioThe decision to start buying individual bonds and move away from bond funds may be a difficult strategic move for many investors. While there may be familiarity with individual fixed income products, an initial purchase may prove a somewhat intimidating experience. In this article, we will take up some of the motivation for weening off funds. Further, we will take up some important considerations as one sifts through the bond universe prior to actually making an investment.

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Why Individual Bonds?

I believe the cardinal reason a bond investor should opt for individual issues versus funds is the return of capital guarantee inherent in an individual bond, barring default. In pooled security products such as open-ended mutual funds, ETFs, and CEFs, capital is inherently at risk. As interest rates and after market bond prices fluctuate, the net asset value of a fund (fund assets – liabilities) also fluctuates, creating the potential for original investment gain or loss. Given the low interest rate environment we live in, the odds are skewed towards a rise in rates, which could put money invested in funds in permanent peril.

When you buy an original issue bond, you are provided with a defined date of maturity, a stated rate of interest, and any contingencies related to the bond (i.e. call features, death put features, etc…), so you know exactly what you own and when you will get the face value of the bond back. If you buy a bond on the open market, you may pay more or less than par value for a piece of a bond (typically 100), but you are still guaranteed the face value of the bond back at maturity.

Another benefit to a bond purchase versus a fund is that there is typically no ongoing fee to own individual bonds. Outside of what should be a fairly nominal brokerage cost, your bond’s interest flows directly to your checkbook. Funds have ongoing costs that eat away at your yield every day and go to the managers’ checkbooks, not yours. These fees can range from rather nominal (< 20 basis points) to astronomical (>200 basis points).

Do I Have Enough To Invest In Individual Issues?

Though there is no set nominal financial rule of thumb to guide investors on when to move out of funds and into individual bonds, one’s assets should be sufficient to ultimately create a well diversified portfolio of numerous issues to mitigate risk. Since I believe in most cases a bond investor has little reason to concentrate positions, I would err on the side of owning more bonds than you need, versus not owning enough. If you have say $250,000 to invest, a portfolio of 25 separate issuer bonds each with $10,000 face value may be a prudent goal. If you have $50,000 to invest, you could own 10 bonds of $5,000 face value, however you are taking on more concentration risk by owning less bonds.

Depending on the brokerage firm and specific issues being considered, there may be minimums involved where you must invest as much as $10,000 or more to get a piece of a bond. But other issues may require just $1000 or less. For optimum portfolio flexibility, issue choice, and potentially a better deal, the larger your asset base and the larger the amount of your minimum purchases, the better.

Picking Bonds To Buy

Given the size of the bond universe, a prospective investor should narrow the field of prospective bonds worth considering. Here is a bullet list of many items worth pondering:

  • Should I consider tax-free investments like municipals or stick with taxable bonds?
  • Do I adequately understand credit risk? Should I consider only highly rated corporate/muni. bonds and treasuries or can I delve into junk? Do I understand credit rating lingo?
  • Why am I buying individual bonds? Portfolio diversity? Stability of principal? How much income do I need to generate from bond purchases?
  • What is my time frame of investment? Do I understand the pros and cons of investing in long as opposed to shorter-term bonds?
  • What is my feeling on the macroeconomy? What will happen to interest rates going forward?

Though the preceding is not a complete list of considerations, it should help narrow your universe of acceptable portfolio choices. Speaking from experience, the first individual bond you purchase will likely be the most difficult. As you build a portfolio and develop a more refined fixed income strategy, purchase difficulty should decrease. There will come a point when you will be able to quickly discern whether an issue represents value in the market and further whether it makes sense in your portfolio.

About the author:

aloisiAdam 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.

 

 

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Adam Aloisi

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.

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