Bond Fund Investment: Right Move Now?

Investing in a bond fund is a topic that has been gaining traction, especially with the interest rate hikes by the Federal Reserve. The decision to invest in a bond fund depends on several factors, including an individual's financial goals, risk tolerance, and investment time horizon. Bond funds offer greater diversification, access to institutional pricing, and professional management. On the other hand, they come with management fees and fluctuating net asset values. Individual bonds, on the other hand, offer a reliable income stream, a predictable value at maturity, and a personalised cost basis. However, they require significant time and resources for research and management and can be costly to achieve adequate diversification.

Pros and cons of investing in individual bonds vs. bond funds

Individual bonds

Pros

• Greater control over your portfolio: you can choose what you buy and whether to hold bonds until maturity or sell them before they mature.
• Greater transparency: you know the maturity dates and coupon payment dates of the bonds you own.
• No ongoing management fees: transaction costs are incurred when you buy and sell, but there are no ongoing fees if you hold the bonds until maturity.
• Predictable income: you'll receive income when a bond makes a coupon payment or matures. Most bonds make coupon payments twice a year.
• Return of principal at maturity: individual bonds are required to repay investors their face value at maturity, providing a level of certainty and security.

Cons

• More time and financial resources: buying individual bonds requires a greater time commitment and financial resources.
• More research and oversight: assembling and managing a portfolio of bonds yourself requires significant research and ongoing monitoring.
• Higher minimum investment: investing in individual bonds typically requires a higher initial investment amount compared to bond funds.
• Less liquidity: with individual bonds, you'll generally receive a cash inflow when a bond makes a coupon payment or matures. If you need to access your principal before a bond matures, you can sell it, but this may entail transaction fees.
• Impact of rising/falling interest rates: when interest rates rise, the market value of individual bonds generally falls, and vice versa.

Bond funds

Pros

• Easier diversification: it's much easier to achieve a diversified bond portfolio with a lower initial investment using a fund because you get exposure to a basket of bonds.
• Access to institutional pricing: bond funds generally receive better pricing on individual bonds than individual investors.
• Professional management: actively managed funds make decisions about which bonds to buy and sell based on huge volumes of information.
• Lower research requirements: you don't need to research individual bonds or issuers.

Cons

• Less control: you have control over which fund you invest in but not over the specific bonds the fund holds.
• Less transparency: mutual funds must publish their complete holdings periodically, but this is often only a few times a year and with a lag.
• Management fees: the more actively traded bond funds can have higher management fees, which may lead to lower returns.
• Fluctuating net asset value: as interest rates rise and fall, the net asset value of a bond fund will also fluctuate.
• Different cost basis and tax consequences: with pooled funds, your cost basis for tax purposes is more complex than if you had purchased an individual bond and held it to maturity. Additionally, you don't have control over the buying and selling of individual bonds, which can lead to hard-to-anticipate capital gain distributions at the end of the year.

Should you invest in a bond fund now?

According to experts, now is a good time to invest in bonds, especially high-quality bonds, as they offer attractive yields compared to the extremely low-rate environment of a couple of years ago. Bonds can lower overall portfolio risk without sacrificing much in terms of returns. However, it's important to note that the decision to invest in bonds and the amount to invest depends on individual circumstances, including financial goals, risk tolerance, and investment time horizon.

How interest rates impact bond prices

Interest rates and bond prices have an inverse relationship. When interest rates go up, the prices of bonds go down, and when interest rates go down, the prices of bonds go up. This is because new bonds are issued with a higher yield, making existing bonds less attractive because they carry less interest. The prices on these lower-rate bonds must be reduced to make them attractive to buyers.

Bond Prices and Yield

The bond's price is the amount that needs to be paid to purchase the bond. The bond's yield is the return received in the form of interest. The current yield of a bond is determined by dividing its annual interest payment by its current price. When a bond's price falls, its yield rises because the annual interest payment remains the same. Similarly, when the price rises, its yield falls because the interest payment is divided by a larger number.

Zero-Coupon Bonds

An easy way to understand why bond prices move in the opposite direction of interest rates is to consider zero-coupon bonds, which don't pay regular interest. Instead, they derive all their value from the difference between the purchase price and the par value paid at maturity. Zero-coupon bonds are issued at a discount to par value, with their yields a function of the purchase price, the par value, and the time remaining until maturity.

If a zero-coupon bond is trading at $950 and has a par value of $1,000 (to be paid at maturity in one year), the bond's rate of return will be 5.26%. An investor can pay $950 for this bond and get the money back plus a 5.26% return a year later. However, if current interest rates were to rise, newly issued bonds might offer a yield of 10%. The zero-coupon bond yielding 5.26% has become much less attractive in the bond market. To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the return yielded by prevailing interest rates. In this instance, the bond's price would drop from $950 to approximately $909.09.

Interest Rates Drop

If interest rates were to drop to 3%, the zero-coupon bond, with its yield of 5.26%, would suddenly look very attractive. More people would buy the bond, which would push the price up until its yield matched the prevailing 3% rate. In this instance, the price of the bond would increase from $950 to about $970.87. Given this price increase, investors selling their bonds benefit from a decrease in prevailing interest rates.

Bond Funds and Rising Interest Rates

Rising interest rates are bad for bonds, and if an investor holds a bond fund during this time, their losses will likely be greater than an investor in an individual bond. When interest rates rise, to avoid further losses, shareholders in a bond fund will liquidate their shares. When this occurs, the fund manager may be forced to sell bonds prematurely to raise enough cash to meet redemption requests. This can have a destructive effect on the average price of a bond fund, called its net asset value (NAV). Hence, bond funds have an additional risk during periods of rising interest rates, referred to as redemption risk.

The benefits of investing in individual bonds

There are several advantages to investing in individual bonds. Firstly, they offer a reliable and predictable income stream, making them great for planning. This stable income is especially beneficial for those with periodic expenses, such as college tuition. Secondly, assuming the bond is not callable, investors can expect to receive the par value of the bond at maturity, barring default. This predictable value can help investors ignore potential price fluctuations if they plan to hold the bond until maturity.

Another benefit of individual bonds is that they offer investors their own cost basis. The price paid to purchase the bond, along with the amortization of any premium or discount, forms the cost basis, which is useful for tax planning purposes. Additionally, individual bonds tend to be less volatile and less risky than stocks, providing more stable and consistent returns. They also perform well when stocks are declining, as interest rates fall and bond prices rise.

Furthermore, interest rates on bonds are often higher than savings rates at banks, on CDs, or in money market accounts. This makes bonds an attractive option for those seeking higher returns without taking on too much risk. Finally, investing in individual bonds allows investors to contribute to their communities. Municipal bonds, for example, are used to fund public projects such as schools, roads, and hospitals, improving the standard of living for many people.

The benefits of investing in bond funds

Investing in bond funds has several benefits. Here are some key advantages:

Diversification

Bond funds provide investors with an easy way to diversify their portfolios. By investing in a bond fund, you gain access to a variety of bonds, including corporate, municipal, and government bonds. This diversification can help reduce overall risk and protect your portfolio from market swings.

Professional Management

When you invest in a bond fund, your money is managed by professionals who have the expertise to research and analyze the creditworthiness of bond issuers and market conditions. They make buying and selling decisions on your behalf, saving you time and effort.

Low Minimum Investment

Bond funds offer a low barrier to entry, allowing investors to gain exposure to a wide range of bonds with a relatively small initial investment. This makes it easier for individuals with limited funds to access a diversified portfolio.

Predictable Income

Bonds are known for providing a predictable and steady stream of income in the form of coupon payments. This can be especially beneficial for retirees or those seeking a stable income source.

Safety and Lower Risk

Compared to stocks, bonds are generally considered safer and less risky. Investing in bonds involves lending money to governments or companies, which then repay the debt with interest over time. This debt is prioritized over shareholder payments in the event of bankruptcy, making bonds a relatively safer investment.

Higher Interest Rates

Bond funds typically offer higher interest rates than traditional savings accounts, money market accounts, or certificates of deposit. This means you can earn a higher return on your investment without taking on excessive risk.

How to buy different types of bonds

There are several types of bonds available for investors to choose from, each with its own unique characteristics and advantages. Here is a guide on how to buy different types of bonds:

• Corporate bonds: These are issued by companies to raise capital for initiatives like expansion or research and development. They are usually sold by brokers or banks but can also be purchased directly from the issuer. The interest earned from corporate bonds is taxable, but they typically offer higher yields than government or municipal bonds.
• Municipal bonds: These are issued by cities, towns, or states to fund public projects such as schools, roads, or hospitals. Municipal bonds are often exempt from federal, state, and local taxes, making them tax-efficient. They can be purchased through brokers or banks.
• Treasury bonds: Also known as T-bonds, these are issued by the US government and are considered risk-free. They can be purchased directly from the US government. While they are subject to federal tax, they are exempt from state and local taxes.
• International government bonds: These are issued by foreign governments and allow investors to diversify their portfolios geographically. They can be purchased through brokers or banks, but it is essential to consider the additional risks associated with investing in foreign governments, such as political instability or exchange rate volatility.
• Agency bonds: Issued by government-sponsored enterprises or federal agencies, these bonds are not directly backed by the US government but are still considered safe due to their government affiliation. They often have higher yields than Treasury bonds but may carry a call risk, meaning the issuer can repay the bond early.
• Green bonds: These bonds are used to fund environmentally friendly projects, such as renewable energy initiatives. They can be purchased through brokers or banks and allow investors to support sustainability while earning interest.
• Bond funds: These are mutual funds or ETFs that invest in a variety of bonds, such as corporate or government bonds. They provide investors with access to a diversified portfolio of bonds managed by professional money managers. Bond funds can be purchased through investment firms or online brokerage platforms.

When buying bonds, it is important to consider factors such as credit ratings, interest rates, maturity dates, and your investment goals and risk tolerance. Additionally, remember that not all bonds are available to private investors due to high minimum purchase requirements or regulatory restrictions.

Frequently asked questions