Buying Bonds: Decisions, Decisions, Decisions!
With interest rates significantly rising in recent months, bonds are increasingly attractive to investors. Assuming that you have decided to add bonds to your portfolio, you will face several important decisions. Here are two key ones for your consideration.
1. Shall I purchase individual bonds or bond mutual funds? This is an important question, and there isn’t one “correct” answer. Let’s explore the pros and cons of both approaches.
Individual Bonds
Pros: A key benefit is control over several factors. These include matching a bond’s maturity to your individual time horizon needs, credit quality, and what you deem to be an acceptable yield-to-maturity. You may also be able to circumvent fund-management fees; however, you’ll need to factor in the costs associated with purchasing individual bonds in order to be sure.
Cons: Although the market for individual bonds has improved, yields are not yet overly attractive. Smaller investors, particularly those without professional guidance, may be challenged to find research on fundamentals and to know if they are paying a fair price for a given bond.
Bond Funds
If you choose individual bonds, focus on high quality and liquidity, and be sure to understand attendant costs and risks. If you elect to use funds, pay attention to internal fund fees and breadth of diversification.
2. Shall I purchase index or actively managed funds? This question can be restated as follows: Shall I purchase a fund that tracks a specific bond market benchmark or attempt to outperform that benchmark by choosing an actively managed fund?
Index Funds
Pros: The key benefits are broad diversification and very low costs…very important considerations given that the range of returns in high quality bond categories is quite narrow.
Cons: Index funds typically lack the flexibility enjoyed by active bond fund managers. For example, they cannot retreat to cash when rates are rising or for other reasons.
Active Funds
If you choose the indexed or “passive” approach, search for and choose the lowest-cost option. After all, bond index funds are a commodity. If all-inclusive bond exposure is one of your goals, be sure that you understand the index or indices you’re exposed to and consider augmenting them with exposure to missing security types, if any.
For an actively managed approach, choose proven fund managers backed by robust analytical resources and strong track records over time. While past performance is never a predictor of future performance, it may provide useful insights about their ability to negotiate challenging markets and economic conditions.
Conclusion
Should I include foreign bonds in my portfolio?
Should I tilt my bond exposure toward certain elements of the bond market, either tactically or strategically?