Should You Invest in Individual Bonds or Bond Funds Today?

Susan Dziubinski:

Hi, I'm Susan Dziubinski for Morningstar. Rising interest rates have led to losses in bond funds this year, leaving some investors wondering if it's better to own individual bonds rather than bond funds today. Joining me to discuss that topic is Christine Benz. She is Morningstar's director of personal finance and retirement planning.

Hi, Christine. Good to see you.

Christine Benz:

Hi, Susan. Good to see you.

Dziubinski:

Let's talk a little bit about walking through why bond-fund holders can experience losses in a period of rising interest rates.

Benz:

Sure. So, as a bond-fund holder, you're basically holding a basket of individual bonds, and those bonds' values get tallied up every day. And what happens when interest rates rise is that the bond prices fall. So, it's possible and, indeed, has happened so far in 2022 where some bondholders have been ready to sell and, over their holding period, they've had a loss because we've seen bond prices fall.

Dziubinski:

How could the scenario play out differently for someone who owns individual bonds rather than bonds through a bond fund?

Benz:

Right. That's why we've been hearing more interest about holding individual bonds. And the virtue of that strategy is that if you buy a bond and the issuer is creditworthy and it's making its payments, you are made whole at the end of that maturity--that when your bond matures, you get your principle back. And so, there isn't that slippage that sometimes bond-fund holders can face in their values. That's why we've been hearing more about investors owning individual bonds or laddering individual bonds, which means that you buy a series of different bonds with varying maturities. That's why there's been more interest in that strategy because of that seeming imperviousness to interest-rate changes.

Dziubinski:

Christine, you've also said though that if you're buying individual bonds, you might end up getting a false sense of security from that. Delve into that a little bit.

Benz:

Yeah. I think the one thing to bear in mind is that if you own an individual bond, its value is jostled around by changing interest rates, too. So, if you need to sell before the bond matures, you could indeed face a loss in that scenario as well. But another thing I think about is that, as individual investors, it can be difficult to amass a sufficiently diversified portfolio where you have exposure to different parts of the bond market, different credit qualities, different maturities. As a small investor, it can be difficult to obtain adequate diversification. You sometimes hear that you need $100,000 to adequately diversify with individual bonds. Well, some smaller bondholders don't have those sorts of resources. So, I think that that's an issue.

Another issue is transparency. Research on individual credits can be difficult to come by. Those would be a couple of the things. And then, the other thing is bid-ask spreads for smaller investors. They can get gouged by trading costs. As a smaller investor in the bond market, you're side-by-side with some of these really big institutional money managers who are able to obtain much better pricing on their bonds.

Dziubinski:

Then at the end of the day, Christine, even if rates are going up, is it still better for most investors to focus on bond funds rather than bonds?

Benz:

I think that investors can safely delve into AAA rated corporate bonds, certainly Treasury bonds, where you're less worried about needing to do the research. But I would say anything that is broader than that, anytime you're venturing beyond those very high-quality credits, you're probably better off in a bond fund. But here's where I would say it's important to keep your expenses really, really low. I think bond funds can be a terrific value in that you obtain built-in diversification and professional management. But we still have really low yields today. So, if you're buying a bond fund, just make sure that your costs are as low as they can be and that will improve your take-home yield and your take-home total return.

Dziubinski:

Christine, thank you for your time today and for your perspective for bond investors. We appreciate it.

Benz:

Thank you so much, Susan.

Dziubinski:

I'm Susan Dziubinski for Morningstar. Thanks for tuning in.

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