Should You Consider Individual Bonds?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Navigating an uncertain bond market environment is very much on investors' minds today. So I'm happy to say that we have Eric Jacobson here. Eric is Morningstar's director of fixed-income research. Eric, thanks so much for being here.

Eric Jacobson: Glad to be here, Christine.

Benz: Eric, one question I have been getting a lot from investors lately, I bet you've been getting it, too, is whether they should be looking at individual bonds right now and that might help them sidestep the threat of rising interest rates.

What do you say to people who are thinking about ditching their bond funds and going with individual bonds with an eye toward maybe just holding to maturity and not worrying about what rates do in the meantime?

Jacobson: It's one of those things where the devil is in the details. In other words, it is possible obviously to buy and hold your bonds and sort of not worry about them, but you have to take into account the fact that if you do have an emergency and you've got to sell them, somewhere in the middle before they've matured, you could have to sell them at a very steep loss, depending on the maturity of the bond at that time.

One of the advantages of a fund is that they're actively managing around that kind of risk. It's not something that's automatically a bad idea, but it requires a lot more thought than I think most people put into it. You also have to reinvest your dividends if you want to keep up with returns.

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Benz: What categories would you say would you urge investors to look at if they are interested in individual bonds and where should they steer clear?

Jacobson: Well, Treasury bonds are probably the best place for an individual to go because you can buy them directly from the government. Even if you buy them through your broker, they're usually sold on a very low commission basis rather than some sort of mark-up or even a high commission for that matter.

Benz: Lots of transparency there for the consumer.

Jacobson: That's right. Pricing is usually very fair. You don't have to worry about getting fleeced. You also don't have to worry so much about analysis of credit risk because unless you want to try and think about whether the Treasury is going to pay off, but we're going to assume that they will.

Also Treasury bonds don't have call options either. You don't really have to worry about getting your money back early and reinvesting it, which is the case with some other kinds of bonds.

Benz: And TIPS as well, would you put into that camp or would you urge investors to look at a fund there?

Jacobson: You can go either way there. I personally favor funds just because there are some real complexities with the way that TIPS are priced. It can be difficult trying to figure out what you want to buy and when you want to buy it, but there's nothing wrong with that. One option that I think a lot of people miss is that there are TIPS savings bonds that can be a really good deal.

Benz: The iBonds.

Jacobson: The iBonds, exactly. That's something people should consider also, but I think you can only buy them up to a certain amount, and if you are a big investor you need to go with the regular bonds.

Benz: Right. So areas that one should absolutely avoid buying individual bonds, can you talk about some of those categories and why?

Jacobson: Sure. In terms of absolute avoidance, you want to stay away from high yield, I think. You're not really going to earn enough to offset the risk of default, probably, unless you're able to build a very large portfolio that's very well diversified. Then the question is how are you going to do the credit research and unless you have a staff of people to do it for you, it's probably not worth it.

There's some other areas that I think that are pretty commonly applied by individuals that I would still suggest looking out for. Just regular investment-grade corporate bonds are one, especially when companies are selling directly to investors.

They may seem like pretty investor-friendly systems and often they are set up nicely to be easy to use. But very often companies do that not just in order to get a better market for their bonds, but to also sell them at a better price for the company.

Benz: I know, Eric, that you have also written about muni bonds being a particular risk spot for smaller investors. Can you talk about what the concerns are there and why you would urge a fund versus an individual bonds?

Jacobson: Sure. It's not impossible. You could buy some really good high-quality municipals without call options. You might be able to get them at a fair price, but it's hard to know. The real problem with municipals is you got municipal risks that are real tough to keep on top of as an individual.

One is simply the credit risk, because over the last several years it's been common for maybe 50%-70% of new bond issuance to come wrapped with insurance. Now we've seen in the wake of the financial crisis a lot of that insurance really wasn't worth what was getting paid for it, but today perhaps one in 10 bonds are coming to market with insurance.

In some ways, that's a good thing because it creates more diversity. On the other hand, it's a lot harder for individuals to try and understand the credit risk of these municipal issues that they are buying. The trick there then becomes even if you feel like you have a handle on it, can you actually buy the bond at the price you think it's worth?

That's a tough thing, too, because they're traded over the counter. They're purchased usually through small securities dealers. And it may be tough as a small investor to really get a fair price.

The other issue is call risk. Most municipal bonds come with some sort of call feature--very often it's 10 years or fewer--and in that case you really want to have some idea of what that call ought to be worth. You should be making more money as an investor because you are giving that call feature to the issuer.

Benz: You have that re-investment risk.

Jacobson: Exactly. If you get that money back early because they call the bond, you want to be able to make sure that you're compensated for that, because at that time you're probably going to have to buy something with a lower yield.

Benz: Right. Right. Well, Eric, those are helpful tips, and I think good advice to people who are thinking about navigating individual bonds versus bond funds. Thanks so much.

Jacobson: Glad to be here.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.