This post was originally made on July 6, 2006 on a former blog of mine.

Buying a mutual fund or ETF is frequently made out to be the solution to the world’s investing ills. As Random Roger is fond of saying, all investment products have flaws in them. Recognizing those flaws and being prepared to accept them is key. Roger also had a post over at his site this week that touched on something I have been meaning to discuss for a while. Namely, that investing in bond mutual funds is a whole different ballgame than investing in individual bonds on your own.

Before I begin this discussion I want to throw out the ubiquitous disclaimer that buying individual bonds may not be for everyone. In fact, if the size of your portfolio is relatively small then the transaction costs and simple entry costs make buying a portfolio of individual bonds prohibitive. If, however, you have the means to purchase a nice diversified portfolio of bonds (diversification of a bond portfolio is a discussion for a different day) then there may be some advantages to buying bonds over simply buying a bond fund.

For those who are a little unfamiliar with bonds let’s give a little bond primer. There are essentially two ways to make money from a bond. The first is from the interest payments paid to you as holder of the bond (also known as its yield). The second is from the capital appreciation that is possible on the bond itself.

Most bonds are issued at a $1,000 par value with a certain coupon (interest) rate attached to them. For our example we’ll say the coupon rate is 4% meaning this bond will pay $40 in interest every year until it matures. Now, the market determines how much someone is willing to pay for this bond. If market and economic conditions warrant (another discussion as well) they may only be willing to pay $950 for that $1000 bond. This means the yield will go up to 4.21% for the buyer ($40 coupon payment/$950 purchase price). Note: this value will change based upon the length of time to maturity. This is just an approximation.

At any given point in time bonds might have very attractive yields and/or their yields might be decreasing and hence improving their capital appreciation. This dynamic is very important to individual bond investors. If bond yields (I am using “bond” as a generic term here, there are lots of different types and risk levels) somehow managed to rise up to say 8% and you found that highly attractive given its risk level then you could lock in that yield by purchasing an individual bond at that price. You would then be paid 8% on your investment until the bond matured, at which point the par value would be returned to you.

The above dynamic is important because when you invest in a bond fund you have no control over when/if bonds are bought and sold and what their yields will be. The manager of your fund takes care of all those decisions for you and their idea of risk/reward may be different than your own. Let’s say they bought a $1,000 par, 4% coupon bond (20 yrs to maturity) at $607 when it was yielding 8%. You may be very happy receiving 8% money on that bond for the duration of the bond period. However, if market conditions change and the bond suddenly increases to $707 in value your manager may be ready to sell the bond and take the $100 capital appreciation (perhaps he needs to boost his quarterly earnings???). You may have been happy to simply accept the coupon payments until the bond matured.

This illustrates the fact that the holders of individual bonds have much greater flexibility in their decision making than the holders of bond funds. To me, the ideal bond portfolio would be made of individual issues with some smaller allocations made to funds in less liquid and more expensive to access bond markets (foreign for instance) if need be. Of course, one needs to be (or have an advisor who is) knowledgeable about the structuring and laddering (of maturities) of bond portfolios to be successful with this strategy but it can offer much greater flexibility if you have the resources.

“One characteristic of winners is they always look upon themselves as a do it yourself project.” -Denis Waitley

Leave a Reply