Bonds play an integral role in the construction of a well-diversified investment portfolio. These debt instruments are typically employed within a portfolio to provide income generation, capital preservation, and volatility reduction. Because bonds can be purchased either individually or through a bond fund, it is essential that distinctions are drawn between the two since they are mechanically different.
Bond funds provide a convenient and liquid way for investors to own a diversified portfolio of fixed income securities that are managed within the parameters of a stated investment objective. A fund will typically invest in hundreds of fixed income securities with varying maturities, qualities, coupons, and prices, that, when blended together in a portfolio, seek to achieve the goals of a given strategy.
To help explain one of the central differences between individual bonds and bond funds, it is important to acknowledge a calculation called duration. Conceptually, duration is rather straightforward: it is a measurement used to determine a bond’s sensitivity to interest rate change. A bond with a duration of 5 years will lose 5% of its value if interest rates increase by 1%. Similarly, if rates decline by 1%, the same bond would increase in value by 5%. With the understanding that interest rates will, at some point, go up, it is critical that investors consider how a rate hike will impact their fixed income assets.
A more time-intensive yet controllable approach to fixed income investing is purchasing individual bonds. Unlike bond funds, individual bonds have a set maturity date on which principal is returned to the bondholder. In an absolute sense, an investor who holds his or her bonds to maturity is not affected by interest rate change and therefore price fluctuation, since they are locked into a fixed yield and the par value of their invested money is returned at maturity. Therefore, holding an individual bond to maturity essentially eliminates interest rate risk. By owning individual bonds, investors are able to more precisely control cash flow since most fixed income securities have a constant coupon rate and a fixed maturity.
The difficulty with investing in individual bonds is that it takes a substantial amount of time and research to identify corporate or municipal debt that is perceivably healthy and can satisfy a particular required rate of return. Understandably, an inverse relationship exists between credit quality and yield –investors are paid more to assume more risk when purchasing debt. The trick then (from the perspective of a buy-and-hold investor) is to identify issuers that are believed to be underrated or positioned for a future upgrade and to lock into a higher yielding bond before its rating improves, which would in turn dilute the yield.
At approximately $100 trillion in size, the global bond market is the vastest and arguably the most difficult to navigate of all capital markets. As we get deeper and deeper into the market cycle, many investors are growing increasingly apprehensive about the stamina of this old bull. Though it’s impossible to say when, a pullback is inevitable. When it happens, will your portfolio be ready? If you have any questions or concerns about your bond portfolio, please contact LBMC for an analysis.