Bond Basics 5: Individual bonds or bond funds? (video)

– Posted in: Investing In Bonds

What is the easiest way to be investing in bonds? Should you own individual bonds or bond funds? The answer is easy. Learn why in this episode. Learn what every investor should know about fixed-income securities.

Video Transcript: Individual bonds or bond funds? (video)

Individual bonds or bond fund? It’s an easy choice!

The major factors in deciding whether to use a bond fund come down to convenience, costs, and control over maturity. You don’t need much diversification if you use CDs and US Treasuries, and you can own these with no purchase fees or annual expenses.

Other individual bonds, on the other hand, can have spreads between the bid price and the asking price from one-half all the way up to five percent, and you will, unfortunately, have no idea that you are paying these hefty fees to your broker.

For most of us, a bond fund is a more efficient way of investing in bonds than buying individual securities. Bond mutual funds are just like stock mutual funds in that you put your money into a pool with other investors to be invested professionally. This can be done at a very low cost.

The thing that some find confusing is that generally bond funds never mature. So while there’s not a specific date when they’ll return what you invested, the fund has a price and you can sell it at any time.

Remember, we don’t expect this price to appreciate, like we would with the stock of a growing company. We care about the total return, which we’ll talk more about later, and sometimes we care about how sensitive that price is to interest rate changes. That sensitivity is best expressed by its duration. A short-term bond fund is less sensitive to interest rate changes than a long-term bond fund.

Test your knowledge about bond funds . . .

Now it’s time for some fun. I’ll give you two facts. You choose the fact that is true.
Here’s one: An interest rate increase can be good for investors. (T)
Here’s the other: A bond fund is just as risky as a stock fund. (F)

This is False. First of all, a terrible year in the stock market is when the value of your investments drops forty to fifty percent. Whereas a terrible year in the bond market might be if interest rates suddenly jump a few percent causing the value of all bonds to drop. Hang on though, if you chose a bond or bond fund that you’ll hold for longer than its duration, then rising interest rates are actually your friend.

This is True. If you reinvest dividends at the new higher interest rate, then you come out ahead if you hold bonds for longer than their duration. Let me make an example to illustrate this.

This investor buys a 30-year 5% Treasury bond at par, and seconds after it is issued, yields suddenly rise to 10%. This bond is now worth less than 53 cents on the dollar. However, since this bond throws off coupons which can be reinvested at the new higher yield, it takes our investor less than 11 years to break even—so this defines the bond’s duration. And note that because of the coupons, the duration is always less than the maturity, sometimes considerably so. To reiterate, after 11 years, this investor is better off for the fall in price because of the rise in yield. The duration is the period of time at which you are indifferent to interest rate changes.(1)

Let’s stop and recap this series so far:

Bonds are essential to every investment portfolio—even when yields are at record low levels—because stocks are so risky. Owning the right amount of bonds helps make that stock market risk palatable. They’re the perfect investment when you need money at a specific time. And bonds that are uncorrelated with the stock market are a very attractive diversifier.

Stocks, Bonds, and Money Market Funds are each very different, and we took a look at this to introduce this current series about bonds. CDs are a special type of bond, and we looked at how and why, sometimes, CDs are better than bonds.

Then we talked about bonds and their two major attributes: the quality (or credit rating) of the issuer, and the length of the bond. We saw how a bond price is tied to the interest rate, and introduced the concept of “duration” to describe price sensitivity.

It is easy to buy CDs and individual bonds from your bank or broker and make a bond ladder. This is interesting for the lowest possible annual expenses, and when you want them to mature on a specific date for some reason.

For most of us, a low-cost bond fund is the way to go and we looked at how duration helps us decide between short-, intermediate-, and long-term bond funds.

The next set of videos to finish this topic will be about the risk and returns of bonds, and tips about how to stay ahead of inflation.

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Footnotes and Video Production Credits for Bond Basics 5: Individual Bonds or Bond Funds?

Footnote 1: “The Duration of Stocks”, William J. Bernstein,
http://www.efficientfrontier.com/ef/999/duration.htm

This video may be freely shared under the terms of this Creative Commons License BY-NC-SA 3.0.

Video copyright 2009-2014 Rick Van Ness.

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