From the 1980s into the 2010s, bond mutual funds have enjoyed a generally favorable environment of increasing prices. Still, mutual fund investors are wise to learn how to build their own diversified fixed-income portfolio, which will include choosing individual bonds.
Even the beginning investor can notice how interest rates were incredibly high in the 1980s, before falling to 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 easy to see how bonds have consistently delivered returns for investors over the past three decades. That makes them worth learning about for any investor interested in building their portfolio.
- A bond fund is essentially a basket of dozens—or hundreds—of underlying bonds being held within one bond portfolio.
- Bond mutual funds carry greater market risk than bonds because the bond fund investor is fully exposed to the possibility of falling prices.
- There are several different types of bonds, but the basic types include corporate bonds, municipal bonds, Treasuries, and junk (or "high yield") bonds.
- Build your bond portfolio with a diverse mix of maturities (one-year, five-year, 10-year, 30-year) and bond types (Treasury, municipal, corporate, high yield).
Learn the Basics of Bonds and Bond Funds
If you have primarily received your bond exposure with bond mutual funds, you will benefit from 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 U.S. government, or a publicly-owned utilities company. These entities issue bonds to raise capital. The money the entity raises helps fund new projects or internal operations. The purchasers of bonds are the investors. They essentially 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 over a stated timeline (the bond's "term"). If held throughout the entirety of that timeline (otherwise known as holding it "to maturity"), and if the bond-issuing entity does not default, the bondholder will receive all interest payments and 100% of their initial investment (their "principal"). Most bond investors do not lose principal since 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, however, do not share this important aspect, which adds to the risk that bond mutual fund investors could lose their principal investment.
Understand the Difference Between Bonds and Bond Mutual Funds
Bond funds are mutual funds that invest in bonds. Put another way, one bond fund is essentially a basket of dozens—or hundreds—of underlying bonds being held within one bond portfolio. Most bond funds are comprised of a certain type of bond, such as corporate or government. They can be further defined by the time to maturity. Maturities are usually grouped as either short-term (less than three years), intermediate-term (three to 10 years), or 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 their principal at the time of maturity. Therefore, there may be no "loss" of principal, as long as the investor holds the bond until maturity and the entity that issued the bond doesn't default on its debt.
Bond mutual funds work differently. 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 knows exactly how much money they'll make if they can hold their bond to maturity.
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 (or "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 other words, you are loaning money to the federal government. There are four types of Treasuries:
- Treasury Bills (T-Bills), which mature in one year or less
- Treasury Notes (T-Notes), which mature in two to 10 years
- Treasury Bonds (T-Bonds), which mature in 20 to 30 years
- Treasury Inflation-Protected Securities (TIPS), which are inflation-indexed bond
Corporate bonds are debt obligations issued by corporations to raise 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, not the government, but they work the same—investors receive a specified amount of interest until the stated maturity date, at which time the original amount of the bond purchase is returned to 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 bonds, 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 bond research. All of the knowledge, terminology, and complexity involved with bond markets can be accessed simply with a few useful strategies and websites. Bond analysts and credit agencies do most of the work for you by assessing the bond risk and assigning a corresponding rating. 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. Whichever financial institution you use for a brokerage or retirement account will also likely give you access to a bond's credit rating and other investing insights.
Avoid Overlap and Strive for Diversification
As with mutual funds, overlap can occur with buying individual bond securities. Try to build your bond portfolio with a diverse mix of maturities (one-year, five-year, 10-year, 30-year) and bond types (Treasury, municipal, corporate, high yield). Within your corporate bonds, try to diversify the industries you're exposed to (financial, health care, manufacturing, retail, etc.).
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 would be wise to consider owning at least one bond mutual fund as a "core" fixed income holding, then building additional investments around that core. It is a type of "core and satellite structure" that's common with complete mutual fund portfolios, though mutual funds typically include stock mutual funds in addition to bond funds.