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The importance of owning individual bonds

By: Jeanie Wyatt

Perhaps the most important investment decision individuals will make is what portion of their portfolio is to be invested in relatively risky stocks versus relatively safe bonds. In this article, I want to briefly discuss bonds, the important role they play in your portfolio and why owning individual bonds is superior to owning bond funds.

Briefly, a bond is an IOU. When you buy a bond, you are loaning money, and when you issue a bond (usually companies or government entities), you are borrowing money. Bonds are typically issued in multiples of $1,000 and pay interest (i.e. “coupons”) semi-annually. The initial principal or amount loaned is repaid when the bond matures, which can range from overnight to 30 years and longer.

Unlike common stocks, bonds do not represent an ownership stake. But bondholders stand in front of stockholders in the event of bankruptcy and liquidation of assets, and bond coupon payments are more certain than stock dividend payments, which can be suspended. Because of this, bonds are generally considered to be safer than stocks.

In fact, bonds can be a great hedge or counterbalance to the riskier stock portion of your portfolio, but you have to choose the right kinds of bonds. In general, bonds face two kinds of risks. The first is default or credit risk, which is the risk that the issuer won’t repay the loan or principal at maturity.

And the second is interest rate risk, which occurs when interest rates in the economy rise. That means that nobody will buy existing bonds at face or “par” value because they can now earn higher rates by buying newly issued bonds. So the price of existing bonds has to fall in order for a buyer (lender) to earn the same yield as offered by new bonds. The yield rises when the price falls because the buyer now pays a lower price, but receives the unchanged interest or coupon payments. That’s what people mean when they say that bond prices and interest rates move inversely.

Unfortunately, these two risks – default risk and interest rate risk – are very difficult to control if you own a bond fund instead of owning individual bonds. In a bond fund, investor funds are pooled together to buy bonds. If interest rates then rise and bond prices fall, other investors will often pull their money out of these bond funds, which have to sell bonds to meet these redemptions at the new, lower prices. That creates a capital loss for those remaining in the fund.

But if you own individual bonds, you can hold them to maturity and get repaid the full principal, even if interest rates do rise. By controlling when the bonds are sold, you can avoid taking a capital loss when interest rates rise. And often, this forced selling means that the bond fund sells its highest quality bonds first, because they often are easier to sell than a less liquid, lower-quality bond. That means that those investors left in the fund now own lower quality bonds, which have a higher risk of default.

The point is that by investing in a bond fund instead of individual bonds, you can end up with increased exposure to credit risk and interest rate risk that is completely out of your control. Plus, bond funds have also made the headlines recently by investing in increasingly riskier assets, like derivative securities and even stocks. For example, Puerto Rico recently defaulted on its bonds, which was the largest municipal bond default in U.S. history. When problems in Puerto Rico first surfaced, it was revealed that more than 70 percent of municipal bond funds owned Puerto Rican bonds.

My message to you is simple: With bond investing as in stock investing, own individual bonds in a separately managed account in your name, not an opaque bond fund that pools your funds with those of other investors.

South Texas Money Management Ltd. is an independent registered investment advisor with $2.7 billion in assets under management. It has five locations around the state. The newest office is in Corpus (located at 921 N. Chaparral, Ste. 112). You may reach this office at 361-904-0551 or www.stmmltd.com. Jeanie Wyatt, CFA, is the CEO and CIO of the firm.

 

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