Invest in Bonds or Bond Funds?
Thursday, November 15, 2012
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 28.8%, down 9.7 points
  Neutral: 22.4%, up 0.8 points
  Bearish: 48.8%, up 8.9 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

On Tuesday, when I was speaking to our Pittsburgh chapter, a member asked whether it is better to buy bonds or bond funds. The answer, as I explained to him, is not simple or straightforward. Rather, it depends on a combination of factors.

Bond funds offer ease and simplicity. A bond fund gives you instant access to a diversified portfolio of bond holdings. I own a bond fund because it makes it easier for me to get fixed-income exposure. The downside is that the typical bond fund, unlike an actual bond, never matures. The price of a fund’s shares and the cash flows you receive will depend on the bond market’s fluctuations—which are influenced by changes in interest rates—and, of course, the manager’s skill. So, bound funds lack a guaranteed rate of return. Furthermore, with a bond fund you will pay ongoing annual management expenses and have no ability to control the timing of capital gains.

Bonds offer a higher (but not absolute) level of predictability. A bond held to maturity will provide a fixed rate of return. At a pre-specified date, you will get the face (“par”) value of the bond back, typically $1,000 per bond. In addition, you will receive semiannual interest (“coupon”) payments. Both of these amounts are fixed for traditional American bonds. Because they are fixed, you know your pretax rate of return when you purchase the bond. This rate of return does not alter so long as you keep the bond to maturity. This is why some bond experts suggest buying actual bonds as opposed to bond funds.

The key is to hold the bond until it matures. Individual bonds offer limited upside, but the risk of a complete loss of your invested capital on the downside. The primary upward drivers of a bond’s price are a decline in interest rates or a credit rating upgrade. Limiting the magnitude of the upside is the fixed return that bonds offer when held to maturity. Excessively overpay for a bond and you will lose money unless you can find someone willing to pay even more. The downside is the potential for losing your entire investment if a default occurs and there are not enough assets to repay you. (A bond is essentially a loan to the issuer.) Defaults tend to be limited among high-credit-quality bonds (though they can occur), which is why bonds are viewed as providing preservation of capital. (In contrast, stocks offer return on capital.)

Bonds can be more difficult to buy than stocks. A single company may issue many bonds. Using General Electric as an example, the company has only one class of common stock that is publicly traded, GE. There are many issues of General Electric bonds, however, with differing maturity and coupon rates. (A search on FINRA’s website identified 500 bonds associated with General Electric.) Thus, while you can call your broker and simply say “buy me X number of shares of GE stock,” you can’t do the same with GE bonds. You will have to give the CUSIP number (the bond equivalent of a stock ticker) or least the maturity or yield you desire. Since there are multiple issues, liquidity (the number of active buyers and sellers) will also differ. Depending on what you are trying to buy and the amount you are looking to invest, it may be challenging to complete a trade.

Thus, the decision as whether to buy a bond or a bond fund should be based not only on your goals, but also on the size of your portfolio, your personal preference about how involved you want to be with your portfolio and whether you want to work with a financial professional who is skilled in building and managing a bond portfolio.

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The Week Ahead

The U.S. financial markets will be closed on Thursday in observance of Thanksgiving. The stock market will close early at 1 p.m. ET on Friday.

Approximately 10 S&P 500 companies will report earnings next week, including Lowe’s Companies (LOW) on Monday, Medtronic (MDT) on Tuesday, and Deere & Company (DE) on Wednesday.

On the economic calendar, October housing starts and building permits will be released on Tuesday. Wednesday will feature weekly initial jobless claims (a day early), the University of Michigan’s November consumer confidence survey and October leading indicators.

Federal Reserve Chairman Ben Bernanke and Richmond President Jeffrey Lacker will speak on Tuesday at separate events.

AAII Sentiment Survey

Bearish sentiment spiked to its highest level since August 2011, as bullish sentiment fell in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 9.7 percentage points to 28.8%. The drop puts optimism at a four-week low. Bullish sentiment is below its historical average of 39% for the 12th consecutive week and the 32nd time in 33 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, edged up 0.8 percentage points to 22.4%. Even with the increase, neutral sentiment stayed below its historical average of 31% for the ninth time in 10 weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, surged 8.9 percentage points higher to 48.8%. This is the highest pessimism has been since August 4, 2011. It is also the 12th consecutive week and the 28th out of the last 32 weeks that bearish sentiment has been above its historical average of 30%.

Bearish sentiment is at unusually high levels, but not so high that it would be considered extraordinarily high. (In statistical terms, pessimism is less than two standard deviations away from its historical average.) The sharp increase comes as the market has pulled back, some large-cap stocks have declined notably over the past several weeks and uncertainty about the fiscal cliff looms. Many individual investors also continue to fret about the slow pace of economic growth and Europe's sovereign debt crisis.

This week's special question asked AAII members whether they planned to alter their portfolio or keep it unchanged given last week's election results. About two-thirds of respondents said they haven't made any or weren't planning on making any changes. Approximately 20% said they are either reducing their stock holdings or favoring less volatile stocks. A few said they were waiting to see what Congress does, or doesn’t do, to resolve the upcoming fiscal cliff.

Here is a sampling of the responses:

  • “I will keep to my present strategy of emphasizing solid dividend stocks and a couple of well-performing growth stocks.”
  • “I’m happy with my asset allocation and don’t need to change it.”
  • “No changes other than taking some capital gains prior to year’s end.”
  • “I plan to continue to tweak my portfolio as opportunities arise, but do not expect to make major sector changes.”
  • “I’m reducing risk and holding more gold.”
  • “My plan is to neither buy nor sell until after Congress acts on the fiscal matters.”

» Take the sentiment survey