The Bond Case

I recently had a conversation about buying individual bonds versus a bond mutual fund. I’m always amazed that investment advisors believe that buying individual bonds is a bad idea. The most cited reason for not holding individual bonds is that you get a terrible price compared to the “Big Boys” at a mutual fund. But the difference in price is less than the 1% that the Big Boys are charging you annually to manage your bond fund (and some funds have much higher annual management fees).

Another argument is that the Big Boys get a much better price when selling. I argue that the Big Boys are probably selling far too often. I’m a big believer in buy and hold, especially with bonds. Get a bond ladder in place and hold the bonds until maturity. You don’t have a selling commission and you get full face value for the bond. Why sell and potentially lose money?

Some say that “you never know when you’re going to need the money NOW!” My first response to that is, “If you have a plan in place with a proper Emergency and Set Aside Fund, you won’t need to liquidate your bonds NOW.” And my second response is, “Does that mean you’re not going to invest in stocks? Because being forced to sell at a bad price is far more likely with equities than bonds.”

I’ve also heard it said that you can’t diversify and will have larger holdings in each bond. This argument implies that if a company defaults on a bond you own, you’ll be out a lot of money. I only recommend buying investment grade bonds which are highly unlikely to default. That’s not to say that investment grade bonds never default, investing your money always carries risk, but an investment grade bond defaulting is not as likely as stock prices falling.

Some will argue that your principal in the bond isn’t protected against inflation. Is any investment “protected” against inflation? Inflation exists and we are always trying to beat inflation. The cash you put in any investment is going to devalue at the same rate, you aim to have the return (growth and income) outpace that devaluation. Money used to buy bonds in a bond fund will be affected by inflation the same as money used to buy an individual bond.

Another concern with bond funds is that it’s not always obvious what you are buying. The Big Boys might appear to “beat the market”, but this is achieved by taking on increased risk with lower grade bonds (which have high yields due to high risk) or by using derivatives (futures and options) that can definitely raise yields in good times, but can also go very badly in bad times.

It seems to me that the Big Boys have done a wonderful job marketing and selling to the masses that you can only invest in bonds if you go through them. I argue, individuals can do just as well or better at a given risk level by investing in individual bonds.

All information provided is general in nature and not meant to be advice for you in particular. I can’t predict the future, the discussion above is my best guess given the current data that’s available to me. If you’d like to know more about how this topic relates to your situation or are looking for a financial planner, contact me.