Learn the Basics on Building a Portfolio of Bonds
The best days of bond mutual funds may be behind investors for a long time. Mutual fund investors are wise to learn how to choose and buy bonds to build their own diversified fixed-income portfolio, which will include individual bonds. But how can a mutual fund investor create their own portfolio?
From the 1980's into the 2010's, bond mutual funds have enjoyed a generally favorable environment of increasing prices. Even the beginning investor can notice how interest rates were incredibly high in the 1980's and were at all-time lows in the years following the Great Recession of 2007 and 2008. Since bond prices move in the opposite direction of bond yields (and prevailing interest rates), it is elementary math and logic to see that bond prices have risen over the past three decades.
Learn the Basics of Bonds and Bond Funds
If you have primarily received your bond exposure with bond mutual funds, you will benefit by learning the basics of how bonds work. A bond is essentially a promise to pay – it’s a loan. The borrower is an entity, such as a corporation, the US government or a publicly-owned utilities company, that issues bonds to raise capital (money) for the purpose of funding projects or to fund the internal and ongoing operations of the entity. The purchasers of bonds are the investors that lend money to the entity, by buying bonds, in exchange for periodic payments with interest.
For example, an individual bond will pay interest, called a coupon, to the bondholder (investor) at a stated rate for a stated period of time (term). If held to maturity, and the bond issuer does not default, the bondholder will receive all interest payments and 100% of their principal back by the end of the term. In different words, most bond investors do not lose principal as can occur with bond mutual funds – there is no real market risk or risk of losing value and the interest payments are fixed, which is why bonds are called fixed-income investments.
Bond mutual funds do not share this important aspect.
Understand the Difference Between Bond and Bond Mutual Funds
Bond funds are mutual funds that invest in bonds. Put another way, one bond fund can be considered a basket of dozens or hundreds of underlying bonds (holdings) within one bond portfolio. Most bond funds are comprised of a certain type of bond, such as corporate or government, and further defined by time period to maturity, such as short-term (less than 3 years), intermediate-term (3 to 10 years) and long-term (10 years or more).
Individual bonds can be held by the bond investor until maturity. The price of the bond may fluctuate while the investor holds the bond, but the investor can receive 100% of his or her initial investment (the principal) at the time of maturity. Therefore, there may be no "loss" of principal as long as the investor holds the bond until maturity.
It is not the same as how bond mutual funds work. With bond mutual funds, the investor does not directly hold the bonds. Bond funds carry greater market risk than bonds because the bond fund investor is fully exposed to the possibility of falling prices, whereas the bond investor can hold his or her bond to maturity, receive interest and receive their full principal back at maturity, assuming the issuing entity does not default.
Know the Basic Types of Bonds (Corporate, Municipal, Treasury, Junk)
There are several different types of bonds, but the basic types include Corporate bonds, Municipal bonds, Treasuries, and Junk (High Yield) bonds:
- US Treasury securities, also known as Treasuries, are debt obligations issued by the United States Department of the Treasury. When you buy Treasuries, you are financing the operation of the United States Federal Government. In different words, you are loaning money to the federal government. There are four types of Treasuries:
- Treasury Bills (T-Bills), which mature in 1 year or less
- Treasury Notes (T-Notes), which mature in 2 to 10 years
- Treasury Bonds (T-Bonds), which mature in 20 to 30 years
- Treasury Inflation-Protected Securities (TIPS), which are inflation-indexed bonds
- Corporate bonds are debt obligations issued by corporations for the purpose of raising capital for corporate projects and other means of expanding the issuing corporation. When you purchase a corporate bond, you are lending money to a corporation, which in turn promises to pay you a specified amount of interest until the stated maturity date, at which time the original amount of the bond you purchased (the principal) is returned to you, the investor.
- Municipal bonds are bonds issued by government municipalities or their agencies. Examples include cities, states, and public utilities. The debt obligations are used to raise money to fund the building of schools, parks, highways, and other projects for public use.
- Junk bonds, also known as high yield, are bonds that have credit quality ratings below investment grade (a rating below BBB by Standard &Poor's or below Baa by Moody's credit rating agencies. AAA is highest). A bond can receive a lower credit rating because of the risk of default on the part of the entity issuing the bond. Therefore, because of this higher relative risk, the entities issuing these bonds will pay higher interest rates to compensate the investors for taking the risk of buying the bonds, thus the name high yield.
Learn How to Research and Buy Bonds
You don't have to be an expert to do your own bond research. All of the knowledge, terminology, and complexity involved with bond markets can be accessed and made simple with a handful of simple strategies and a few useful websites. There are bond analysts and credit agencies that do most of the work for you. Therefore, the bond investor only needs to know where to look and how to interpret the information that already exists.
You can use mutual fund research sites to see what some of the best mutual fund managers are holding in their portfolios for some ideas. Then you can move to do your own research by looking at sites, such as investinginbonds.com.
Avoid Overlap and Diversity
As with mutual funds, overlap can occur with buying individual bond securities. If you have several different bonds in your bond portfolio, you may not be properly diversified. Try to have differing maturities (i.e., 1-year, 5-year, 10-year, 30-year), differing bond types (i.e., Treasury, Municipal, Corporate, High Yield) and differing industries among corporate bonds (i.e., financial, health, manufacturing, retail).
Consider a Core and Satellite Portfolio Structure
Even if you feel the price risk of mutual funds will be prevalent for quite some time, there is no reason to abandon bond mutual funds completely. For diversity's sake, investors will be wise to consider owning at least one bond mutual fund as a "core" fixed income holding and building around it. It is a type of "core and satellite structure" common with a complete mutual fund portfolio, which would also include stock mutual funds in addition to your bond funds.
The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.