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By Samuel Lee | 01-31-2014 11:00 AM

Are Individual Bonds Right for You?

No, with few exceptions, says Morningstar's Sam Lee.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We hear from many investors that they are looking at individual bonds versus bond funds as a way to protect themselves in a rising-rate environment. I'm here with Sam Lee, a strategist and also editor of Morningstar ETFInvestor, to see if that's a good strategy.

Sam, thanks for joining me today.

Sam Lee: Good to be here.

Glaser: A lot of investors think that buying individual bonds versus bond funds helps protect them somewhat, that if they just hold them to maturity they won't feel the pain of rising interest rates. Is this a fallacy?

Lee: Absolutely. And it's one that's surprisingly common. Supposedly authoritative sources like Suze Orman actually advocate this strategy of buying in high-quality individual bonds and holding them until maturity on the theory that this protects you against interest-rate rises. And that's absolutely false.

And I think one of the reasons why this fallacy exists is because it's very seductive to think that if you ignore the bond price and you just look at the income, you're going to get a steady stream of income, and then finally you are going to get a lump sum of your principal back in the future. And people think that they are shielded from interest-rate risk. But that's actually not the case because individual bonds have market prices.

If you buy an individual bond and interest rates rise, the market price of that bond will fall. And just because you ignore the market price doesn't change that fact. When you invest in a bond when interest rates are low, you basically have locked in a stream of payments at that low interest rate. When interest rates rise, you can now actually get same stream of payments for a lower price. So, basically you've lost the opportunity to invest in higher-yielding assets.

And another way to think about this is with mutual funds. It's actually kind of fishy when you think about it that [people think] if you hold the bond in your personal account and you completely ignore its price, that somehow you're protected from interest-rate risk but that if you put it into a bond fund, suddenly interest-rate risk is all over the place and you are suddenly no longer safe. But that's also another fallacy because nothing changes about the future cash flows of a bond when you stick it in a mutual fund.

Some people think that the mutual funds lock in losses because they have to roll over bonds. They have to buy new bonds and they have to meet redemptions and additions of money. But that's not the case. So, think about the individual investor in his brokerage account holding an individual bond, and let's say interest rates rise. That investor, if he decides to sell his individual bond at the market, he is going to get a lower price than what he paid for it. But the thing is with that sum of money he can actually buy basically an identical bond with the same stream of income. So the act of buying or selling a bond doesn't actually lock in losses in any real sense.

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