This article is an extract from a conversation held between Morningstar’s Jeremy Glaser, markets editor, and Samuel Lee, strategist on the passive funds research team.
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?
Absolutely. And one that's surprisingly common.
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.
Another way to think about this is with mutual funds. It's actually kind of fishy that people think that 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. This is also a fallacy because nothing changes about the future cash flows of a bond when you stick it in a mutual fund.
Some people think that 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. 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.
Is there ever a case when individual bonds make sense?
Certainly, but it's 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 5 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.
Another one is when you are a very high-net-worth individual. 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.
But for the vast majority of investors sticking to bond mutual funds is probably the best bet.
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