By Peter Mastrantuono
Even though bonds make up a substantial portion of investors’ portfolios, many investors have little understanding of just how complicated building a sound bond portfolio is.
Before building a bond portfolio that fits your needs and objectives, you first need to think about whether to invest in individual bonds or through a bond mutual fund or ETF.
Individual Bonds vs. Bond Funds
There are good reasons why you might choose to build a portfolio of individual bonds, including having specific yield objectives and a target date requirement for the return of your principal investment. For instance, some advisors create portfolios of individual bonds designed specifically to generate monthly income for their retired clients.
Individual bonds may also be more appropriate when looking to execute a specific portfolio strategy, such as a laddered bond portfolio.
Nevertheless, a professionally managed bond mutual fund or ETF may be the better alternative since most investors do not have the knowledge or resources to sufficiently analyze the range of factors that can affect their investment results, such as bond covenants, call dates, issuer leverage, capital structure rank and market liquidity.
Additionally, individuals do not enjoy the same access to, and pricing power of, an institutional investor, like a mutual fund, which means that an investor won’t always see all the available bonds or get the same prices when buying or selling a bond as an institutional investor does.
It’s also harder to create a well-diversified portfolio with individual bonds. Factors such as correlation of the bonds within the portfolio, managing overall portfolio duration and ascertaining the portfolio’s interest rate and credit risks are best left to professional managers.
Finally, bond holdings need to be continually monitored since the economic, industry and company-specific conditions that affect a bond’s value are ever-changing.
Key Considerations for Evaluating Bonds
Similar to stocks, you should fully understand a bond and its issuer before investing. The primary factors you need to evaluate include:
- Interest rate risk: Rising rates will cause the value of a bond to decline, depending upon the magnitude of the rate increase and the bond’s duration.
- Credit risk: An issuer’s financial condition (current or in the future) could lead to a downgrade in credit rating, leading to a drop in a bond’s value.
- Idiosyncratic risk: Issue characteristics, such as whether a bond is selling at a discount or premium, its call features, whether the bond has a sinking fund provision and other bond covenants that require issuer actions, all may affect market pricing.
- Event risk: Events, including a merger, acquisition, leveraged buyout, or corporate restructuring, all may impact the financial health of the bond issuer and consequently affect a bond’s price.
Bond mutual funds and ETFs also face these same risks, but do benefit from professional management and broad diversification. Nonetheless, you should fully understand the nature of any prospective bond fund investment before investing to ensure it matches your income objectives and risk tolerance.
Bond investing can be complicated, but with the guidance of an experienced financial advisor you may find the process less stressful and the results more satisfying.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.