Should you invest in individual bonds or bond funds today?

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Suzanne Dziubinski: Hello, I’m Susan Dziubinski for Morningstar. Rising interest rates have led to losses in bond funds this year, leaving some investors wondering if holding individual bonds is better than bond funds today. Christine Benz joins me to discuss this topic. She is Director of Personal Finance and Retirement Planning at Morningstar.

Hi Christina. Happy to see you.

Christine Benz: Hello Susan. Happy to see you.

Dziubinsky: Let’s talk a bit about why bond fund holders can suffer losses in times of rising interest rates.

Benz: Sure. So, as a bond fund holder, you essentially hold a basket of individual bonds, and the value of those bonds is tallied up every day. And what happens when interest rates rise is that bond prices fall. So it is possible and indeed it has happened so far in 2022 where some bondholders were willing to sell and during their holding period they suffered a loss because we have saw bond prices fall.

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

Benz: To the right. That’s why we’ve heard more interest in holding individual bonds. And the virtue of this strategy is that if you buy a bond and the issuer is solvent and makes their payments, you get paid back at the end of that maturity – that when your bond matures, you get your principal back . And so there’s not that slippage that bond fund holders can sometimes face in their values. This is why we hear more about investors holding individual bonds or laddering individual bonds, which means you buy a series of different bonds with varying maturities. This is why there has been more interest in this strategy due to this apparent insensitivity to changes in interest rates.

Dziubinsky: Christine, you also said that if you buy individual bonds, it might give you a false sense of security. Dive into it a bit.

Benz: Yeah. I think the only thing to keep in mind is that if you own an individual bond, its value is also affected by changes in interest rates. So, if you have to sell before the bond matures, you could also incur a loss in this scenario. But another thing I’m thinking about is that as an individual investor, it can be difficult to build a sufficiently diversified portfolio when you’re exposed to different parts of the bond market, different credit qualities, different maturities. As a small investor, it can be difficult to achieve adequate diversification. You sometimes hear that you need $100,000 to adequately diversify with individual bonds. Well, some small bondholders don’t have that kind of resource. So I think that’s a problem.

Another issue is transparency. Research on individual credits can be difficult to find. That would be some of the things. And then the other thing is the bid-ask spreads for small investors. They can get ripped off by transaction costs. As a small investor in the bond market, you are on the side of some of these very large institutional fund managers who are able to get much better prices on their bonds.

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

Benz: I think investors can safely dive into AAA-rated corporate bonds, certainly Treasury bonds, where you’re less worried about having to do research. But I would say anything broader than that, anytime you venture 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 terrific value as long as you get built-in diversification and professional management. But we still have very low yields today. So if you buy a bond fund, just make sure your costs are as low as possible and that will improve your net return and your net total return.

Dziubinsky:
Christine, thank you for your time today and for your perspective for bond investors. We appreciate that.

Benz:
Thank you very much, Susan.

Dziubinsky: I’m Susan Dziubinski for Morningstar. Thanks for listening.

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