Is the best way to invest in bonds to buy individual IOUs or shares in a bond fund? “We get this question all the time,” says Collin Martin, head of fixed-income strategy and research at the Schwab Center for Financial Research. “And every time, I give the same answer: It depends.”
Mutual and exchange-traded funds certainly make bond investing easy. You pay an annual fee, of course, but the initial investment outlay is low, the fund offers instant diversification, and experts do all the work.
But for investors who seek a specific level of income or who have cash needs at a specific time in the future, a portfolio of individual bonds can make a lot of sense. There are pros and cons to investing in individual bonds, however, and much to consider if you want to invest that way.
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The main upside to holding bonds to maturity is that doing so neutralizes interest rate risk. Bond prices and interest rates move inversely — when rates rise, bond prices fall, and vice versa.
When the Federal Reserve hiked rates 4.25 percentage points in 2022, for instance, the Bloomberg U.S. Aggregate Bond Index sank 13.0%. But when you hold individual bonds to maturity, interest rate fluctuations don’t impact your coupon or principal payouts.
Better yet, when you plan to hold individual bonds to maturity, you know with near certainty, barring a default or an early payoff, exactly when and how much money you’ll get back. That certainty of a payout at maturity is one reason an investor with a looming large expense — a balloon payment on a home equity loan, say, or a tuition bill — might opt to invest in individual bonds.
“Few investments give you that kind of predictability,” says Martin.
But it’s not for everyone. At least $100,000 is required to build a well-diversified portfolio of corporate or municipal bonds, spread across 10 different bonds in different sectors, among other traits, says Martin.
At U.S. Bank, $250,000 is the preferred minimum for a portfolio of high-quality corporate bonds, says Bill Merz, head of capital research at U.S. Bank Asset Management Group. “And that’s 25% to 30% of the total portfolio,” which will include stocks and other assets.
The larger the transaction size, the better the price and the easier it is to execute. Although it’s possible to buy corporate and municipal bonds in $5,000 tranches, if you invest less than $10,000 in any given bond issue, you may find it difficult to trade, says Schwab’s Martin.
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Be prepared to research and monitor your individual bond holdings. The sheer number of bonds on the market can be daunting. Ford Motor (F) has one symbol for its common stock, for example, but hundreds of distinct bonds, says Richard Carter, vice president of fixed income strategy at Fidelity.
Proper vetting is required to ward against the risk of default. In a portfolio of individual IOUs, every holding matters. “A default can meaningfully impact the portfolio yield,” says Merz. That’s less of a risk in a fund that holds 1,000 securities.
If you don’t have the time or the appetite to do the work required, a bond fund makes better sense. Certain pockets of the bond market — low-grade credit, such as high-yield municipal bonds, high-yield corporate debt and bank loans — are better suited to mutual funds or ETFs, too.
Instead, focus on high-grade sectors such as certificates of deposit, Treasuries, and investment-grade (rated triple-A to triple-B) corporate bonds or municipal debt, and plan to hold to maturity if you’re going to buy individual IOUs.
Many online brokers, including E*Trade, Fidelity and Schwab, offer screening tools to help you select individual issues. It helps to have a rough idea of what you’re looking for at the start. To that end, consider the following traits below to begin narrowing your choices.
Time horizon matters when buying bonds
When do you need your money back? Match your time horizon with the bonds you’re investing in. “If you have a two-year time horizon, don’t invest in a 10-year bond,” says Martin.
A bond’s maturity and its interest rate risk are connected. Bonds with a one-year maturity are less sensitive to interest rate moves than a 10-year bond.
Keep an eye on credit risk, too
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Even within high-grade debt, default risks can vary. A triple-A bond has less credit risk than one rated triple-B. But two single-A bonds issued by different companies may differ, too.
If one yields more than another, for instance, there’s probably an added risk. For that matter, the credit quality of a triple-B bond issued by a firm with improving fundamentals may be more attractive than that of a bond rated single-A from a company with deteriorating fundamentals.
“Look at the issuers yourself. Don’t blindly follow the credit ratings,” says Erin Kolo, manager of private wealth management equity and fixed income research at Baird.
Key bond terms to know
Coupon rate is the fixed annual rate of interest a bond issuer promises to pay. That’s different from current yield, which fluctuates depending on the bond’s price (it is the bond’s annual income divided by its current market price). The greater the risk, the bigger the potential reward, so a bond’s yield can be a telling clue in that regard.
Yield to maturity is the all-in return you would get from coupon payments and the repayment of principal. Yield to worst is the lowest possible yield a bond investor can receive without the issuer defaulting.
Call features of a bond
Most high-quality corporate debt is callable, which means after a certain period the company can “call” in the bond and pay it off before maturity. That allows firms to refinance if rates have fallen, for example.
But what’s good for the firm is not always beneficial for bondholders. Although a callable bond typically yields more than a noncallable counterpart, if your promised coupon payments end, you’ll have to reinvest elsewhere, potentially at lower interest rates.
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The bond tools at Fidelity and Schwab allow you to sift for “call-protected,” or noncallable, bonds. But that can limit your choices. Fortunately, both tools also allow you to view the terms on a callable bond, and it pays to check. A callable Walmart issue that matures in April 2028 can’t be called until March 2028, for example, just one month before it matures. “Some might say, that’s not material. It doesn’t really matter,” says Fidelity’s Carter.
At a minimum, if you’re weighing an investment in a bond that’s callable, pay attention to its yield to worst to get a measure of what your return would if the bond gets called, says Baird’s Kolo.
A bond ladder, an investing strategy that involves buying multiple bonds with staggered maturities, is one of the best ways to build and maintain a simple bond portfolio. As one bond matures, reinvest the principal into a new bond at the far end of the ladder. Or use the proceeds to cover necessary expenses. If college tuition bills start in 2027, for instance, you’d buy Treasuries maturing in 12-month intervals over the next four years, just in time to cover the bills.
Some online brokers, including Schwab and Fidelity, offer tools that can help you build and maintain a bond ladder. Schwab’s tool is limited to CDs and Treasuries; Fidelity’s covers those asset classes, plus corporate and muni bonds.
Building a bond ladder is one way to create a more predictable income stream, but deciding how bonds fit into your broader retirement or investment strategy can be more complicated.
Use the Bankrate tool below to connect with a financial advisor to create a portfolio that aligns with your income needs, risk tolerance and long-term goals:
Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.