Buying Bonds in Today’s Markets
Fixed income securities - commonly known as bonds - consist generally of treasuries (issued by the U.S. government), corporate (issued by companies), and municipal (issued by local municipalities) bonds. They serve an important purpose in investment portfolios by providing diversification, which reduces risk and enhances returns. Similar to stocks, an investor may buy individual bonds, a bond mutual fund, or a bond ETF. Which is the better approach? You won’t be surprised to hear…it depends!
In today's interest rate environment, buying bond mutual funds or ETFs may be the way to go. Here’s why:
Currently, interest rates are low and bonds are expensive. Under these conditions, it makes better sense to fulfill bond allocations with ETFs and mutual funds which will allow the investor to benefit from a future rising interest rate environment. ETFs work particularly well for those investors with smaller portfolios, and bond mutual funds for larger portfolios. Bond mutual funds tend to be actively managed and will benefit from future higher interest rates as the fund manager rebalances portfolios with new bond issues. These rebalancing actions occur naturally due to portfolio turnover and new money coming into the fund which then needs to be invested.
Contrast this with an investor who buys an individual bond position at the currently low coupon rate and high prices. If interest rates begin to rise, the investor has two options: hold the low interest bond to maturity and continue to receive a low coupon payment; or sell the bond at a discount to its par value. Either choice is not optimal.
Bond mutual funds and ETFs are also ideal for investors with smaller portfolios. A mutual fund and ETF will hold a large number of individual bonds, which provides a diversification benefit that’s hard to replicate for the smaller investor.
When is it a good time to buy individual bonds?
Buying and holding individual bonds is great in a falling interest rate environment. Your bonds will increase in value as interest rates fall, and your bonds will provide a higher coupon rate than current rates. You have the advantage - you can sell the bonds at a premium or continue to receive a higher coupon payment until the bond matures.
Holding individual bonds is also beneficial if you have a sufficiently large asset base that can afford to buy a diverse portfolio of bonds to fulfill a specific allocation.
Understanding the pros and cons of different fixed income investments will allow you to be strategic with your bond purchases. Keep an eye on the current - and expected - interest rate environment to determine your best course of action. Click below to schedule a call with us.
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