Back in the late 1990s when I worked for the "big bull," I adhered to the asset allocation theme. I would typically invest a percentage of a client’s portfolio in multiple asset classes and hold them, perhaps even rebalancing on occasion. Once in a while, I would buy individual bonds in lieu of funds, but I used bond funds the majority of the time. Several years ago, I abandoned the practice of 'buy and hold' as it only works when the market is going up (come to think of it…. everything works when markets are going up!). Today, I am tweaking my approach by using individual fixed income in certain portfolios. Why individual bonds over funds? When should you consider using individual bonds? Here are my thoughts on the subject.
Why Buy Individual Bonds?
Bond funds have an additional risk that individual issues do not possess. When rates rise, and they will, bond funds will experience outflows. A fund manager might be forced to sell issues to meet redemption requests which may erode the performance of the fund. Also, rising rates will depress the price of the existing bonds in the fund. On the other hand, individual bonds contain a high degree of predictability, a feature which is quite attractive today. A typical portfolio of individual bonds will provide a "yield-to-worst" and a "yield-to-maturity." The "yield-to-worst" applies when there are callable issues in the portfolio. This is the return the investor will earn if the callable issues are called at their earliest call date and the others are held to maturity. In the absence of callable issues – or if they are present, but are not called – the "yield-to-maturity" is the more accurate number. Because this is a known number, there is a greater degree of predictability with individual issues. As a result, individual issues provide a higher degree of stability to a portfolio than bond funds. Of course, there is the risk of default with individual bonds. To mitigate this risk, you could buy highly rated, insured issues.
When to Buy Individual Bonds?
I would suggest buying individual bonds when the total bond allocation exceeds $250,000 (+/-). I would also buy individual bonds of at least $25,000. This is because smaller pieces are less attractive if you decide to sell an issue before maturity. Today, I also recommend laddering the maturities. Let's say you were buying 10 issues of $25,000 each. You could buy a 2014, 2015, 2016, all the way to 2023. When the 2014 matures, invest the proceeds into a 2024 bond. Assuming yields have risen, you will be reinvesting at a higher rate, and therefore, raising the yield on the entire bond portfolio.
For a deeper dive into fixed-income investing, please see my March 2011 feature story in Investment Advisor.
Thanks for reading and have a great week!