May 25, 2022
In light of the recent rise in interest rates, I thought it would be a good time to dive into the difference between owning individual bonds and owning bond mutual funds. On this episode, I’ll discuss the key differences between the two and what you should be looking for in your retirement portfolio.
You will want to hear this episode if you are interested in...
- An overview of bonds [1:00]
- Taking a closer look at bond mutual funds [5:38]
- What about owning individual bonds? [11:07]
Reviewing bonds
One of the most important decisions an investor can make regarding their portfolio is their asset allocation. This is the amount of money you divide between growth investments such as stocks, real estate, and commodities versus safer investments like bonds and cash. Once you determine your allocation amount for bonds, it’s important to understand the types of bonds available for purchase. The first are corporate bonds, which pay the most in interest but carry the most risk. Next, there are municipal bonds, that also have varying degrees of risk, depending on the municipality you're buying them from. And lastly, there are treasury bonds backed by the U.S. government that most people consider the safest bonds you can buy.
Regardless of which type of bonds you own, the greatest challenge with investing in bonds is rising interest rates. Bond prices and interest rates have what is known as an “inverse relationship”, where they always move in the opposite direction of each other. When interest rates go down, bond prices tend to go up. Likewise, as interest rates go up, bond prices are driven down. One way around inflation is through purchasing I bonds, but you can only purchase up to $10,000 worth per person, per year.
Mutually beneficial investment
You have two choices when it comes to deciding how you want to own your bonds: you can own bond funds or purchase individual bonds. Owning bonds through a bond mutual fund allows you to put your money into a pool with other investors. A financial professional then invests that money according to what they think the best opportunities are. You can purchase funds that specifically invest in corporate, municipal, and treasury bonds or go with a fund that invests in a lucrative mix at the bond manager's discretion.
An extremely important thing to look at when purchasing mutual bond funds is the internal cost of the fund known as the “expense ratio”. Funds with lower expense ratios tend to yield higher returns due to lower operating costs, so it’s important to keep track to have a successful retirement portfolio. Another aspect of bonds that you can control is the length of their duration/maturity. If you believe that interest rates will continue to rise, you have the option to purchase shorter duration bonds to prevent further declines in value. However, the trade-off is that you will lose out on the often higher interest rate of medium to long-term bonds. Listen to this episode for more information on individual bonds and bond mutual funds!
Resources Mentioned
- Understanding Bonds and How to Use Them, #15
- Increase Your Cash Return With I Bonds, #84
- Bankrate
- Morningstar