BY: Daniel M. Savage
Assuming that you have decided to add bonds to your portfolio, you will face several important decisions. Here are two key ones for your consideration.
Shall I purchase individual bonds or bond mutual funds?
This is an important question, and there isn’t one “correct” answer. Let’s explore the pros and cons of both approaches.
A key benefit is control over several factors. These include matching a bond’s maturity to your individual time horizon needs, credit quality, and what you deem to be an acceptable yield-to-maturity. You may also be able to circumvent fund-management fees; however, you’ll need to factor in the costs associated with purchasing individual bonds in order to be sure.
Although the market for individual bonds has improved, yields are not yet overly attractive. Smaller investors, particularly those without professional guidance, may be challenged to find research on fundamentals and to know if they are paying a fair price for a given bond.
Bond fund investors gain the twin benefits of diversification and professional management in a single package. Both elements have the potential to enhance return and lower risk. There may also be cost savings via a large institutional investor’s ability to obtain lower trading costs.
Internal fund management fees may reduce your return, so be sure to clearly understand their magnitude in light of performance. Rising rates and other negative factors may depress prices, thereby preventing you from withdrawing as much as you invested in the fund.
If you choose individual bonds, focus on high quality and liquidity, and be sure to understand attendant costs and risks. If you elect to use funds, pay attention to internal fund fees and breadth of diversification.
Shall I purchase index or actively managed funds?
This question can be restated as follows: Shall I purchase a fund that tracks a specific bond market benchmark or attempt to outperform that benchmark by choosing an actively managed fund?
The key benefits are broad diversification and very low costs…a very important consideration given that the range of returns in high quality bond categories is quite narrow.
Index funds typically lack the flexibility enjoyed by active bond fund managers. For example, they cannot retreat to cash when rates are rising or for other reasons.
Primary advantages include the potential to outperform a given bond market benchmark and to avoid trouble spots. Unlike their index brethren, active managers can retreat to cash when rates are rising; moreover, they can often capitalize on emerging opportunities. Finally, internal fund fees for many of the better/best funds have significantly decreased in recent years, thereby improving their odds of outperformance without assuming excessive risks.
First, my comments above notwithstanding, actively managed funds generally have higher internal fees, so it’s important to pay careful attention when choosing them. Second, an active manager may position a fund in one way only to see the market move in a different direction. Think, “betting on the wrong horse.” Finally, some active funds are tightly constrained in certain respects and may not be able to achieve that outperformance as anticipated.
If you choose the indexed or “passive” approach, search for and choose the lowest-cost option. After all, bond index funds are a commodity. If all-inclusive bond exposure is one of your goals, be sure that you understand the index or indices you’re exposed to and consider augmenting them with exposure to missing security types, if any.
For an actively managed approach, choose proven fund managers backed by robust analytical resources and strong track records over time. While past performance is never a predictor of future performance, it may provide useful insights about their ability to negotiate challenging markets and economic conditions.
If bonds are destined to play a role in your future, the two questions above and their respective answers will help you take your next steps. To be sure, there are additional important questions like the following:
Should I include foreign bonds in my portfolio?
Should I tilt my bond exposure toward certain elements of the bond market, either tactically or strategically?
The answers to these questions are more complicated and require careful consideration, so it may be beneficial to consult with an experienced Wealth Manager before making a decision.
Successful investing is anticipating the anticipations of others.
John Maynard Keynes
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