Is Investing in Individual Bonds Right for You? - dummies

Is Investing in Individual Bonds Right for You?

By Russell Wild

Individual bonds and bond funds, like politics and money, are even closer than most people think. Here are some things to consider when deciding whether individual bonds make sense for you.

Dispelling the cost myth

People who imagine great differences often say that bond funds are more expensive than investing in individual bonds. While this statement is often untrue, the expenses associated with bond funds have traditionally been more visible than those associated with trading individual bonds.

Overall, funds tend to be less expensive unless the individual bonds are bought for very large amounts and held till maturity (provided maturity is at least several years away).

Dispelling the predictability myth

Another misconception is that individual bonds are much more predictable than bond funds. After all, you get a steady stream of income, and you know that you are getting your principal back on such-and-such a date. Technically, these things are true. But they’re more complicated than they seem.

Say you had all your money in one big, fat bond worth $100,000 with a coupon rate of 5 percent, maturing in 20 years. You would know that you’d get a check for $2,500 once every six months and that, in 20 years, provided the company or municipality issuing the bond is still around, you’d get a final check for $102,500 (your final interest payment, plus your principal returned).

But that’s not how things work in the real world. In the real world, investors in individual bonds typically have bonds of varying maturities. As one bond matures, a younger bond takes its place.

Except by rare coincidence, the new bond will not have the same maturity period or the same coupon rate. So the argument that the returns on a portfolio of individual bonds are as predictable as the sunrise is weak.

In addition, consider the effects of inflation. Yes, $100,000 invested in individual bonds today will be returned to you in 10, 20, or however many years, depending on the maturity of the bonds. But what will that money be worth in 10 or 20 years? You simply don’t know. Because of inflation, it could be worth quite a bit less than the value of $100,000 today.

Dispelling the interest rate risk avoidance myth

Interest rate risk — the risk that general interest rates may go up, making the value of your existing bonds (paying what are now no longer competitive rates) go down — can really put a damper on the life of a bond investor. That is especially true when interest rates are so low that they can really only move in one direction: up.

Sometimes, when people get scared, they get stupid. And stupid is the argument that buying individual bonds is a way of avoiding interest rate risk.

Here’s how the argument goes: Buy an individual bond, hold it until maturity, and you will be immune from interest rate risk. Let those bond fund buyers suffer from depressed prices. You will get your principal back, in full, in 20 (or whatever) years. So the interest rate can go up and down, down and up, and it wont affect you at all!

While this argument is technically true, it is, like the predictability argument, more complex than it first seems. Sure, go ahead and buy a bond for $1,000 that pays 5 percent for 20 years. Then say that next year, interest rates on similar bonds pop to 7 percent.

You are going to hold that bond for another 19 years. You aren’t going to sell and take a loss like all those idiots who bought into bond funds last year, are you?

Well, that’s your option. But know the cost: For the next 19 years, all things being equal, you will collect 5 percent on your initial investment. Everyone else, perhaps even those bond fund holders, may be collecting 7 percent a year. Sure, you’ll get your $1,000 back eventually. But you are taking a loss in the form of locking in your principal at the lower interest rate.

Dispelling the tax myth

This one isn’t so much a myth: The reality is that bond mutual funds can incur capital gains tax where individual bonds — until perhaps you sell them — do not. When a fund manager sells an individual bond for more than he paid for it, the fund makes a capital gain that gets passed onto the shareholders (if there are no offsetting capital losses).

With individual bonds, you often don’t incur a capital gains tax unless you yourself sell the bond for a profit — or you buy a bond at a discount to par and you hold it to maturity.

Embracing the precision of single bonds

Neither price nor consistency makes individual bonds all that much a better option than bond funds. What can sometimes make individual bonds a better option is control. If you absolutely need a certain amount of income, or if you need the return of principal sometime in the next several years, individual bonds can make sense. For example:

  • If you are buying a house, and you know that you’re going to need $40,000 in cash in 365 days, buying one-year Treasury bills may be a good option for your money.

  • If your kid is off to college in two years, and you know that you’ll need $20,000 a year for four years, Treasury bills and bonds may be the ticket. (However, it may make more sense to open a 529 College Plan.)

  • If you are comfortably retired and your living expenses are covered by your pension and Social Security, but you need to pay out $500 twice a year for property taxes, it may be wise to put away enough in individual bonds to cover that fixed expense, at least for several years down the road. (Beyond several years, you can’t be certain what your property taxes will be.)

  • If you are pulling in a sizeable paycheck and find yourself in the upper tax brackets, and you live in a high-tax city and state, then a ladder of triple-tax-free munis may be your best portfolio tool. (Tripletax-free means free from federal, state, and local tax.)

  • If you are getting seriously on in years, and your life expectancy isn’t that great, and you suspect that your heirs will inherit your bond portfolio in the next several years, you may want to consider a bevy of individual corporate bonds with death puts.

Individual bonds allow for a precise tailoring of a fixed-income portfolio, with certain potential estate benefits. Quite simply, most people don’t need that kind of precision or insurance, and, therefore, the advantages of funds usually outweigh the advantages of single bonds.