5 Reasons to Avoid Buying Bonds Directly

Today, with bond yields low, owning individual bonds may be the wrong thing to do. Why? Because bond yields will rise, probably dramatically, when the Federal Reserve begins backing away from the easy-money policy that has driven interest rates down to record lows. That will pummel individual bondholders because bond yields and prices move in opposite directions.

Yes, holders of individual bonds will continue to collect their interest payments. But when yields rise, inflation normally does, too. The after-inflation return on these individual bonds will turn sharply negative.

Given that most bond mutual funds also are likely to lose some value when rates start to rise, why is a fund any better?

1. You can sell a fund at net asset value five days a week. With individual bonds, brokers often offer 3% to 5% less than the bonds are worth. No broker wants to buy the relatively small bond pieces that individual investors own, so no one offers remotely fair prices.

2. Managers can use derivatives to adjust the sensitivity of their bond funds to changes in yields. Some bond funds, should lose little or nothing when rates rise because it's deploying some of its assets to sell Treasuries short — that is, betting that they will fall in price.

3. A bond fund can take risks that would be imprudent for an individual investor. If you own five or ten individual bonds, you can't afford for even one of them to go bust, so you have to stick to the highest-quality issues. But if you're a fund manager and you own hundreds of issues, it's reasonable to take some risks on at least a portion of them in return for higher yields.

4. Managers have at their disposal analysts who are much better equipped to dissect an individual bond than you are. Come to think of it, fund analysts generally do a better job of assessing a bond's safety than the bond-rating agencies do.

5. Whatever value is left in the bond market today — and there's precious little — can be found only in debt that few individuals are capable of analyzing on their own. I'm referring to high-yielding junk bonds, emerging-markets bonds and some mortgage securities. For these, you need the diversification and, yes, the professional management that a bond fund provides.

Source:  Steven Goldberg, Kiplinger's

D2 Capital Management uses a variety of bond mutual funds and bond managers to maximize diversification in our client accounts.

The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.

 

The Jacksonville Business Journal has ranked D2 Capital Management in the top 25 of Certified Financial Planners in Jacksonville.  The Firm is also a member of the Financial Planning Association of Northeast Florida.