By Alan Goldfarb, CFP®
Here is a question that has appeared in various forms lately:
"How do you respond to your clients who "hear" that now is the best time to invest in individual bonds and the worst to invest in bond funds?"
This question yields two interpretations. Firstly, investors are hearing that bonds are currently a great investment - better than equities, real estate, gold, etc. - but that curiously bond funds are poor investments. In the second interpretation, investors are hearing that however bonds stack up against other assets, individual bonds are a superior investment to bond funds. In either case, the advice is misleading.
Yes or No on Bonds
If investors are hearing the first interpretation, they are receiving information that is entirely inconsistent and wholly illogical. The only time bonds are a great investment is when all other asset classes are likely to fall or when yields are expected to fall and thereby produce capital gains in bonds. If that prospect applies to individual bond holdings, it should apply to any bond fund that is even partly well managed. To choose one approach over the other is meaningless in this context, except that a fund offers other advantages in a fast-moving market.
As it is, there is little likelihood of major declines in yields going forward. Long yields and short rates now stand near 40-year lows and, with the economy improving, the next likely move for the Federal Reserve (Fed) policy is probably a rate increase. Given low rates of inflation and still considerable concern about the economy's health, such an increase will probably wait until next spring, at the earliest. And then, the Fed will likely move rates up gradually. Because long yields already stand well above short rates - an historically wide yield gap - short rate hikes should have little affect on long yield, if any effect at all. But even though bonds should defend well, it is hard to make a case for bonds generally over other asset classes, such as equities. This conclusion applies equally to funds as well as individual bond holdings.
Among bond choices, the best prospects actually lie in those with equity-like qualities, such as convertible bonds and high yield. These sorts of assets should see their value rise with the economy's improving prospects and outperform treasuries, high-grade corporate bonds and similar instruments. In these favored areas, the case for funds over individual holdings is strong. Though the prospects for high yield and convertibles looks good in general, there is great risk in any individual holding. An investor needs strong diversification in order to take advantage of the more general prospects and the facility to monitor relative values on an ongoing basis, across a broad range of securities. Unless the investor has a massive portfolio and extensive resources to devote to its management, funds are the only way to capitalize safely on the attractive opportunities in these areas.
Relative Comparisons
The second interpretation of the question is more subtle. The prospect of a rise in yields might make some fearful of capital losses in funds and seek the assurance that individual holdings will at least repay their principal. These attitudes are understandable but ultimately misleading. To be sure, a rise in yields would impose capital losses on most general bond funds. It will do the same to individual bond holdings as well, but they will eventually mature and presumably pay their principal. If that maturity date also marks the end of the investment process, then perhaps the individual holdings are a decent idea. But if the investment process is ongoing, then it is illogical that individual holdings are superior to bond funds.
With an ongoing investment process, the maturation of existing holdings requires that the manager reinvest the funds, whether that manager is the individual bond holder or the employee of a fund. If rates have risen, those reinvestments would occur at higher yields and cheaper prices - an attractive prospect for the individual holder and the bond fund alike. Both have equal opportunity to roll money from their maturing bonds into higher-yielding, lower-priced instruments. Of course, the fund usually holds many more bonds than the individual holder and tends to make adjustments more gradually. If the holder of individual bonds is lucky, his or her maturity will arise at an opportune time and perform better than the fund's more gradual rollover. Any superior performance in this regard would, however, be luck, since no one has the ability to forecast reinvestment rates at maturity. This is a chance some investors might wish to take, but the risk-averse investor should prefer the more gradual approach of the fund. It is, after all, closer to the principles of dollar cost averaging.
In the end, the real purpose of a bond is to produce steady, predictable income - a very different investment dynamic than that of stocks, which provide capital appreciation. Investors who confuse the two are often disappointed if they expect an asset to perform a function beyond the scope of its design.