by Daniel Putnam | August 9, 2013 9:35 am
For investors in or near retirement, one of the most important questions is deciding whether to own bond funds or individual bonds. While this is an age-old debate, the currently fragile status of the bond market argues for a fresh look.
And by almost any measure, individual bonds are the better bet for retirement-oriented investors who have the time and inclination to do the necessary research.
The crux of the case for individual bonds over bond funds lies in the long-term outlook for interest rates. Although rates are higher than they were two months ago, they remain low on a historical basis. This indicates that there is little room for meaningful capital appreciation in bond funds over and above the already-low coupon.
On the other hand, the potential for several years of below-average returns is relatively high, and — in terms of “tail risk” — the odds of a meltdown are greater than the chance for a sustained, multi-year rally. With yields so low, it will only take a modest amount of share price depreciation to cause returns to fall below the rate of inflation.
For those who require investment income, that just doesn’t cut it.
This adverse risk-return profile is especially important for those invested in bond funds, since the lack of a specific maturity date means that any loss of principal could take years to recoup. Individual bonds, on the other hand, offer two key advantages.
First, investors who emphasizes high-quality bonds with a low likelihood of default are able to minimize or even eliminate the principal losses that can occur with bond funds. Even if yields rise sharply, investors can sleep at night knowing that market fluctuation isn’t going to take a toll on their hard-earned savings.
Second, rising rates can actually work to the benefit of investors in individual bonds by allowing them to purchase higher-yielding securities as their current holdings mature. In a negative-return environment, the value of these two attributes can’t be overstated.
Individual bonds aren’t going to make anyone rich. Conservative investors will find bonds maturing in seven years, issued by AA-rated companies such as International Business Machines (IBM), Coca-Cola (KO), Colgate Palmolive (CL), and PepsiCo (PEP), that offer yields to maturity well-north of 2%.
Bonds issued by the AAA-rated companies Microsoft (MSFT) and Johnson & Johnson (JNJ), both due in 2020, yield 2.63% and 2.67%, respectively.
Vanguard Total Bond Market ETF (BND) — which invests across the spectrum of the domestic investment-grade bond market — has a comparable yield of 1.98%, but it also experienced nearly a 5% drop in its share price during the May-June sell-off.
This downturn would have had no long-term impact on the retirement savings of someone in individual bonds (unless he or she had been forced to sell). This could prove extremely important if the second-quarter disruption proves to the beginning of a long-term trend, and not just a blip.
The downside of owning individual bonds, though: the added research, making sure you get a favorable price without too much of a mark-up, and the need to monitor the account and ensure proper diversification.
Many investors don’t have the skills to do this; others simply just want to enjoy their retirement. In this case, a mix of conservative bond funds makes sense even with the shaky longer-term outlook.
The debate regarding bonds and bond funds will likely rage on forever. But for investors who are trying to make the most of their retirement savings and minimize the risk of rising rates, individual bonds make more sense than ever.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.
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