Bonds are usually considered the safe portion of an investment portfolio. But investing in bonds can yield some unpleasant surprises.
The bond market has dynamic quirks of its own and can require sophisticated investment strategies, particularly in today's interest rate environment.
Bond fund or individual bonds?
The bond market is extensive. Institutions of all kinds issue bonds to raise money. The easiest for individuals to buy are Treasury securities. Investors can go to TreasuryDirect.gov and buy Treasury bills, bonds or notes directly.
It gets a little more complicated to buy bonds issued by businesses, local governments or private institutions.
Retail investors compete against institutional investors as well as investment professionals who buy large lots of bonds for their clients. That means the best bonds may never be seen by individuals. And if they are seen, the price may not be as good as it is for people buying larger quantities, and trade execution can be a little slower.
"When I see a good bond now, I have about four seconds to hit the buy ticket or it's gone. That means the retail investor is going to be buying the issues that nobody wants to buy," says Bill Larkin, fixed-income portfolio manager at Cabot Money Management in Salem, Mass.
Though that's not always the case, investors should be aware the deck may be stacked against them.
Buying individual bonds allows investors more control over their investments, but as with individual stocks, their investment portfolios need to be sufficiently large to accommodate the number of bonds necessary for proper diversification.
Herbert Hopwood, president of Hopwood Financial Services in Great Falls, Va., stocks his clients' portfolios with 20 to 30 individual bonds of differing issuers, sectors and maturities.
"You have to be very careful about saying, 'I'm going to only buy one bond, and it's going to be a big part of my portfolio.' The idea is that you want some diversification. I would suggest looking at corporate bonds -- 10 different issuers at least. If someone has $50,000 to do this, they may be better served by using a bond fund," he says.
Attributes of bond funds
The disadvantage of bond funds is their ongoing fluctuation in price. Whereas a highly rated individual bond purchased at par value can be held to maturity with no apparent loss of principal, bond funds, which constantly buy and sell bonds, are priced daily. This means they're subject to price fluctuation, and investors can lose money.
An investor who holds an individual bond to maturity can ignore all price changes that would affect selling the bond on the secondary market. Barring default, the investor will receive the face value at maturity.
Rising interest rates can also negatively affect the price of the bonds in a fund. As interest rates go up, so will the coupon rate on newly issued bonds. The price of existing bonds will fall because their interest rates are lower, so investors are compensated for the discrepancy when they purchase those bonds at a discount.