If you’re investing for retirement, chances are that you’ve bought some bonds. But did you buy yours individually or as part of a bond index?
The difference may seem insubstantial. And for the last 35 years, it has been. But times are changing. The Fed is finally starting to pick interest rates up off the floor. Since bond prices are inversely related to yields, this nearly four-decade-old bull market in bonds may be coming to an end.
There actually are some subtle differences between buying individual bonds and bond indexes. But in a bear market, those differences might not be so subtle - they could significantly impact your income and returns.
In this article, we’re diving into the not-so-nitpicky differences between investing in individual bonds and bond indexes.
The Basic Differences Between Bonds and Bond Indexes
One of the biggest differences between a bond and a bond index is the way they handle maturity dates.
An individual bond has a fixed maturity. There’s a date written on the actual piece of paper. On that date, the holder receives the full value of the bond, and the interest payments stop. Thus, if you buy a 10-year note and hold it for five years, then it becomes a five-year note.
If you know anything about bonds, the above paragraph might seem extremely obvious. But we’re pointing out these characteristics because they don’t apply to bond indexes. Instead, bond indexes and funds tend to maintain rolling maturity time frames.
In other words, a 10-year bond index always holds bonds that are 10 years from maturity. It reinvests in new bonds on a staggered basis as the old ones mature. This ensures a constant maturity time frame and a consistent stream of income from the coupon payments.
Why does this difference in maturity characteristics matter? Because in a bear market, it could make a big difference in the market value of your bond portfolio.
The Advantages of Individual Bonds
Assuming that you hold them to maturity, individual Treasury bonds are the safest investments in the world - hands down. Your principal investment is protected by the full faith and credit of the U.S. government. And you receive a fixed income payment, usually twice a year.
Cost is another advantage that individual notes hold over bond indexes. Depending on who you buy your bonds from, you might pay a markup. But that’s the only fee you’ll ever have to pay on that investment. Bond funds and indexes have management fees, but no one will charge you money for owning individual bonds.
However, if you decide to sell your individual bonds before maturity, that safety goes out the window. Selling a bond before maturity means accepting the market price. And at the moment, prices are going down as yields go up.
So if you hold individual bonds to maturity, then they’ll be cheaper and more reliable investments than index funds. But if you don’t want to be locked into your investment for years, then you could be risking a big loss when you sell.
The Advantages of Bond Indexes
If you’re less concerned with preserving your principal and more concerned with drawing a regular income from your bonds, then bond indexes may be the way to go.
Bond funds stagger purchases of new bonds to ensure a more frequent and regular flow of income. Most funds send their investors a check every month, rather than twice a year. These payments might fluctuate a bit, but funds try to keep them around a stated average.
Bond indexes do experience some market risk, unlike an individual bond held to maturity. But on the other hand, the indexes are diversified for you. They tend to hold broad portfolios of bonds with varieties of characteristics and sources. As a result, they generally have less risk than an individual bond that is bought and sold on the secondary market.
Bonds have always been known as a safe-haven investment. And they will continue to have that reputation in the future - no matter which way interest rates are going.
But now that we may be at the brink of a bond bear market, some of the conventional wisdom about bonds is out of date. Namely, bonds and bond indexes are no longer interchangeable. In this environment of rising interest rates, choose between the two carefully. Otherwise, you could get burned by the Fed’s wacky lending policies.