What can you do to prepare yourself for higher interest rates?
“My broker says that if interest rates rise, I’d be better off owning individual bonds than bond funds because I can hold a bond to maturity,” an investor said recently.
We believe that investors are far better off with bond funds than individual bonds, particularly if markets change, and here are three reasons why:
1. Diversity: Funds help you stay diversified and mitigate risk
With individual bonds, you’ll likely be able to only hold a handful at best, so your risk will be concentrated in just a few holdings. If any one of those companies defaults on its debt or goes bankrupt, you could be left with pennies on the dollar, or nothing at all. And if that unlucky bond were 10% or 20% of your fixed-income portfolio, it would really hurt.
Bond funds are far more diverse. Most funds own hundreds, if not thousands, of bonds, so if one bond defaults, the other positions can help offset losses. Funds also have research teams devoted to evaluating each company’s creditworthiness before purchasing bonds.
Larger funds may even negotiate more favorable status (higher positioning on the capital structure) with bond issuers or banks due to their sizable positions. Sometimes, it just pays to go with a pro.
2. Liquidity: Funds make it easy to move on when markets change
What if you don’t want to hold a bond to maturity? What if you want to quickly adjust your portfolio in response to market conditions or you need to access some cash? Funds offer greater liquidity than individual bonds. In other words, they’re easier and cheaper to sell.
You can sell a fund at any time and in just about any market condition, and you’ll get the fund’s next closing price (NAV). But if you try to sell an individual bond, you’ll likely find that you’re selling at a lower price than you saw on your broker’s website that day.
If you’re considering owning individual bonds, you should test this out: call your broker and ask what price you’d get if you sold a bond. Chances are your selling price would be 1% to 2% less than the bond’s stated value. We've seen some bonds that sold for 5% to 6% less. Spreads are often particularly wide if you’re selling a bond with a face value of less than $100,000 or if you’re trading in volatile conditions. With bonds yielding just 2% to 5% a year, that’s a steep price to pay.
3. Flexibility: Funds give you access to important areas of the bond market
If you’re buying individual bonds, you’re typically limited to high-quality, low duration bonds, because those are the bonds that won’t require deep research or professional expertise. But that narrow area of the bond market may not always be the best performer.
With funds, you can capitalize on opportunities in other areas, such as lower quality bonds, like high yields and bank loans (floating-rate securities), or foreign or emerging market bonds, and there are times when these areas of the bond market shine.
This originally appeared on Forbes.