Here's a statement of the obvious: The opinions expressed here are those of the participants, not those of the Mutual Fund Observer. We cannot vouch for the accuracy or appropriateness of any of it, though we do encourage civility and good humor.
"If you own bond funds or bond ETFs you should conduct an immediate review. Taking personal control of your bond allocation requires owning bonds, not bond funds."
Reply to @catch22: The author, who is a financial advisor, merely points out the risk associates with bond funds or bond ETFs with respect to raising interest rate. One can lost value in their principal (decline bond prices) while maintain the yield in interest rate hike. So avoid long duration bonds and use short/intermediate term duration bond funds instead.
The author suggests buying individual bond and hold to their maturity date, the principal will be paid in full along with the coupon yield regardless of interest rate. Also create a bond ladder to ensure income stream. However, this will require bond selection skills and large $$ for diversification. These the exact reasons individual investors use mutual funds/EFT to gain broad bond exposure, and professional actively management.
The first link, on individual bond investing, IMHO understates both the risks of individual bonds and the capabilities of bond managers to deal with the issues the author raises. I have a fair amount invested in both individual bonds and in bond funds, so I'm not saying this because I particularly favor funds over individual securities, or because I'm inexperienced with funds.
He suggests investing at least $20K (read his comments below the article), because he suggests 5 maturities of 3 bonds, bonds are sold in $1K denominations, and when one buys bonds one needs to prepay accrued interest (hence the excess over $15K). This is in pretty severe disagreement with nearly everything I've read that typically suggests you start with $100K for a taxable (non-Treasury) bond portfolio or perhaps $50K for a muni portfolio.
See, e.g. CNN/Money saying that the overhead of buying 1-sees 2-sees is too high, you need to buy bonds in lots of 10. (My experience is that it difficult to even acquire bonds in lots sizes under 5, though I'm not sure one gets that much better a price for 10 than for 5.) Or this longer article from Fidelity that suggests at least $100K, with $200K being preferable for a corporate bond portfolio, There's a table that contains their suggested min number of issuers needed to protect against default. From it, you can infer the $50K I mentioned for munis.
The post says only to buy investment grade bonds, yet the Fidelity (and other) articles point out that BBB bonds (still investment grade) have default risk many times higher than A rated bonds. The post says to avoid bonds on negative watch. (The Fidelity article says that bonds with the highest yield are likely to be downgraded - essentially that you can tell if a bond is on negative watch, actual or virtual, by its pricing.) But why would one purchase an AA3 bond on neutral watch over an AA2 bond on negative watch if one would get similar yields? The "no negative watch" rule is too simplistic.
The post says that bond prices must go down as interest rates go up. Well sure, if you're sticking with the vanilla bonds he's talking about buying. But one of the virtues of bond funds is that they have access to a much broader spectrum of bonds. (They also buy bonds with a much lower overhead than you would.) I'm a fan of Bob Rodriguez (FPA New Income) in part because he explicitly uses interest only (IO) bonds - these rise in price as interest rates rise (because the underlying bonds are less likely to be paid off early, thus increasing the total income stream). PIMCO unconstrained bond fund can create a portfolio with negative duration (actually negative effective modified duration), meaning that as interest rates go up, the value of the portfolio will go up too. And so on. Lots of stuff that a fund can do that an individual investor can't - including managing cash flows to minimize the impact of outflows (which is something Vanguard excels at in its stock funds).
All that said, I do have a modest sized muni bond portfolio. For various reasons, including the fact that (as pointed out in Fidelity's table) munis don't present nearly the risk that corporates do - so they're easier to deal with, and you can build a portfolio with fewer issuers. The yield curves are better behaved than corporates (i.e. they tend to reward longer investments regardless of the economic climate, though the curvature does still change over time).
When you invest in individual bonds, you need to be aware of call risk, and plan accordingly. I've had the occasional surprise where I expected a bond to be called and it wasn't (the good news being that I get to keep a higher coupon bond, the bad news being I don't have the expected access to that cash). But in general, it's not too hard to deal with callable bonds, and they can provide greater liquidity and/or yield than one gets with call-protected bonds. There's a lot more to buying bonds than simply picking five maturities, fifteen A-rated companies, and plunking down your cash.
I haven't even gotten into taxation of individual bonds. I followed the poster's link on the subject, which then took me through several other pages, and finally to the IRS site, with no explanation (other than from the IRS) on how to deal with taxation of secondary market bonds. There are much better sites (e.g. InvestingInBonds.com)
The bottom line is that the choice of vehicle (individual securities, fund) is nowhere near as clear cut as advocates for either approach make it appear.
Comments
http://merrilledgeminute.com/content.do?action=displayContent&cid=696603&oid=&pollId=10701&xsl=110/MerrillEdgeMinute.xsl
As to the author's viewpoint........
"If you own bond funds or bond ETFs you should conduct an immediate review. Taking personal control of your bond allocation requires owning bonds, not bond funds."
To each our own path, eh?
Take care,
Catch
The author suggests buying individual bond and hold to their maturity date, the principal will be paid in full along with the coupon yield regardless of interest rate. Also create a bond ladder to ensure income stream. However, this will require bond selection skills and large $$ for diversification. These the exact reasons individual investors use mutual funds/EFT to gain broad bond exposure, and professional actively management.
He suggests investing at least $20K (read his comments below the article), because he suggests 5 maturities of 3 bonds, bonds are sold in $1K denominations, and when one buys bonds one needs to prepay accrued interest (hence the excess over $15K). This is in pretty severe disagreement with nearly everything I've read that typically suggests you start with $100K for a taxable (non-Treasury) bond portfolio or perhaps $50K for a muni portfolio.
See, e.g. CNN/Money saying that the overhead of buying 1-sees 2-sees is too high, you need to buy bonds in lots of 10. (My experience is that it difficult to even acquire bonds in lots sizes under 5, though I'm not sure one gets that much better a price for 10 than for 5.) Or this longer article from Fidelity that suggests at least $100K, with $200K being preferable for a corporate bond portfolio, There's a table that contains their suggested min number of issuers needed to protect against default. From it, you can infer the $50K I mentioned for munis.
The post says only to buy investment grade bonds, yet the Fidelity (and other) articles point out that BBB bonds (still investment grade) have default risk many times higher than A rated bonds. The post says to avoid bonds on negative watch. (The Fidelity article says that bonds with the highest yield are likely to be downgraded - essentially that you can tell if a bond is on negative watch, actual or virtual, by its pricing.) But why would one purchase an AA3 bond on neutral watch over an AA2 bond on negative watch if one would get similar yields? The "no negative watch" rule is too simplistic.
The post says that bond prices must go down as interest rates go up. Well sure, if you're sticking with the vanilla bonds he's talking about buying. But one of the virtues of bond funds is that they have access to a much broader spectrum of bonds. (They also buy bonds with a much lower overhead than you would.) I'm a fan of Bob Rodriguez (FPA New Income) in part because he explicitly uses interest only (IO) bonds - these rise in price as interest rates rise (because the underlying bonds are less likely to be paid off early, thus increasing the total income stream). PIMCO unconstrained bond fund can create a portfolio with negative duration (actually negative effective modified duration), meaning that as interest rates go up, the value of the portfolio will go up too. And so on. Lots of stuff that a fund can do that an individual investor can't - including managing cash flows to minimize the impact of outflows (which is something Vanguard excels at in its stock funds).
All that said, I do have a modest sized muni bond portfolio. For various reasons, including the fact that (as pointed out in Fidelity's table) munis don't present nearly the risk that corporates do - so they're easier to deal with, and you can build a portfolio with fewer issuers. The yield curves are better behaved than corporates (i.e. they tend to reward longer investments regardless of the economic climate, though the curvature does still change over time).
When you invest in individual bonds, you need to be aware of call risk, and plan accordingly. I've had the occasional surprise where I expected a bond to be called and it wasn't (the good news being that I get to keep a higher coupon bond, the bad news being I don't have the expected access to that cash). But in general, it's not too hard to deal with callable bonds, and they can provide greater liquidity and/or yield than one gets with call-protected bonds. There's a lot more to buying bonds than simply picking five maturities, fifteen A-rated companies, and plunking down your cash.
I haven't even gotten into taxation of individual bonds. I followed the poster's link on the subject, which then took me through several other pages, and finally to the IRS site, with no explanation (other than from the IRS) on how to deal with taxation of secondary market bonds. There are much better sites (e.g. InvestingInBonds.com)
The bottom line is that the choice of vehicle (individual securities, fund) is nowhere near as clear cut as advocates for either approach make it appear.