Are Individual Bonds Right for You?

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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Glaser: Why does this persist? Why do people think individual bonds are a better bet?

Lee: One thing is, there are certain brokerages that don't offer daily quotations for bonds, especially less liquid municipal bonds. So people think that if there's no daily quotation, then the price didn't actually fluctuate. But that's the illusion of the lowest sort. Others, because I think they have a financial incentive to perpetuate this myth, especially financial advisors--I think that most of them are well-intentioned, but then there's also that incentive that comes along when they get to manage a portfolio of individual bonds because individual bonds are often sold for very steep premiums to individual investors. And when an individual wants to sell them, they have to sell it at a pretty steep discount. So there's a lot of commission income involved in managing portfolios of individual bonds, and it also increases the perceived importance of advisors when they say, "Oh, you have to invest in individual bonds. You can't do it yourself. Let me help you out."

Glaser: Is there ever a case when individual bonds make sense?

Lee: Certainly. But I would say for most investors, it's very, very rare. Individual bonds are perfect when you have a known future payment or series of payments that you have to make and you want to completely eliminate the risk of not being able to make those payments. Let's say you're going to buy a house five years down the road and you know for sure. And you have a lump sum of money. You can put your money in a bond that matures on the date that you want to buy the house. And so you have basically immunized the risk of putting your savings in something that might go up and down and leave you unable to meet your obligations in the future.

A lot of pension funds actually do this or have been doing this in recent years, in which they know that they have to make a series of payments decades out into the future. What they'll do is, they'll actually buy long-maturity Treasury bonds to completely match the liabilities they have. So, individual investors can do this. But it's a relatively rare circumstance.

Another one is when you are a very high-net-worth individual who is also very tax-sensitive. Having a separately managed portfolio of individual bonds gives you greater timing and control over when you want to realize losses and gains on individual bonds. So there are tax savings there. But for the vast majority of investors sticking to bond mutual funds is probably the best bet.

Glaser: What should investors do if they are worried about rising rates? Are there any strategies that can help protect them?

Lee: Simply put, reduce your duration [a measure of interest-rate sensitivity] risk, and the way you do that is you get out of very long-duration bonds and go into shorter-duration bonds. A lot of people don't realize that if you invest in a short-duration bond right now, say, something that matures within the next few years, you are going to get close to no yield at all. And it actually puzzles me when people buy these short-duration bond funds and bond exchange-traded funds because they can actually get higher yields in their bank accounts.

So if you go online, go to bankrate.com or whatever, you can search for certificates of deposit and high-yield bank accounts that yield 1.5% to 2.0%. And that's actually a relatively good deal compared with what you get in the bond market right now. If you invest in the Barclays Aggregate Bond Index, you are going to get something about a 2% yield. So these high-yield bank accounts and bank products are very competitive with conventional bonds right now and are vastly superior to many short duration bond products out today.

Glaser: It sounds like investors should stick to bond funds or maybe cash and not worry about individual bonds.

Lee: Yes.

Glaser: Sam, thanks so much for joining me today.

Lee: Good to be here.

Glaser: For Morningstar, I'm Jeremy Glaser.

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