I have a lot invested in Vanguard's bond index fund. Is there any
advantage to buying individual bonds? I am quite overwhelmed on all
the ratings, A, AA, AAA and then municipal/corporate. I understand the
basics, but don't see how to make an informed decision? Should I just
stick with the index funds?
The big advantage of an individual bond over an index fund is that with
the individual bond, assuming the issuer does not default, you will
always recover you principle and earn the specified interest rate if
you hold the bond to maturity.
If you buy a fund there is no maturity so if you buy when rates are low
and rates go up the price of the fund's shares will drop. If the fund
has a duration of five years the price of the fund shares will drop 5%
for each 1% increase in interest rates. There is no point in time when
you are guaranteed to get your principle back.
IMHO the ratings are not worth much. Remember that most of the CMOs and
CDOs that became worthless during the recent meltdown were rated AAA by
the same rating agencies that rate bonds. If you do plan to buy
individual bonds you need to perform the same financial analysis on
each company you would perform if you were buying the companie's common
The costs of buying individual bonds can be substantial unless you are
very careful. This is particularly true of municiple bonds which are
frequently very illiquid. Most muni issues don't trade once a year so
if you have to sell you may take a substantial loss.
When and if interest rate goes up, bond funds are going to go down.
Individual bonds are going to keep paying the same interest if you
don't sell them. Not true of bond funds.
(Some pundits are predicting that eventually interest rate is going to
go up, thus bond funds values are going down.)
Homer, it's pretty standard to see the bond vs. bond fund arguments
(offered above) that hinge on potential principle loss. And (for some
reason) the advantage typically goes to bonds over bond funds. I'll
offer a different point of view:
Bond proponents typically dote on the fact that you can hold a bond to
maturity and evenutally get your principle back. But I never hear
anyone note that we're not talking about bonds with one year
maturities here. Bond rates are typically (and currently) lower for
shorter term bonds. The only way to get the highest interest rates is
to buy bonds with long-term maturities (like 20+ years). Who can wait
that long if they need the cash? What are the chances you're going to
be near maturity when the liquidity need arises? Who can predict their
needs that far into the future? And, of course, if you have to sell
prior to maturity, you're no better off than had you bought bond funds
(probably worse off, depending upon a specific set of facts).
Moreover, when looking at 20+ year time periods, there's a good chance
that interest rates are going to both rise and fall. With a bond
(bought today at some paltry rate) the market price is almost always
going to be lower than the maturity amount (rates can't practically
get any lower than they are now). But a bond fund continually
reinvests into the market. That means that not only will your income
climb as rates increase, but if rates begin to fall (again) you can
sell AT A GAIN! So a bond fund provides the OPPORTUNITY to get out
early and actually make money. Given todays incredibly low interest
rates, I can nearly assure you that won't happen with an individual
bond. If current rates were higher, bonds would also have this
Nevermind the inherently greater risk associated with buying
individual bonds. It takes a rather large sum of money to buy enough
bonds to both diversify your holdings and overcome the fixed cost of
buying those bonds. You probably need $500k or more.
Once ALL things are considered, I see more people go into bond funds
than actual bonds for all of the reasons stated above. The trick is to
simply make sure that you have other sources of liquidity (hence
eliminating the need to sell). If you have absolutely no other sources
of cash, then either your financial plan is setup incorrectly or
you're trying to put too much into fixed income.
I like the overall concept. The income can be scheduled based on
maturities. The return does not depend on market conditions after the
bonds are purchased. It is possible to trade off risk and return. Of
course default is a risk.