Let's Talk about Bonds (Part 3)

By Gary Silverman, CFP®

Last week, in our continuing look at bonds, we noticed that if you bought a bond—in our example, a 20-year bond—but wanted to sell it before the 20 years were up, you wouldn’t necessarily get what you paid for it. In fact, it is extremely rare for that to happen. This can be good or bad as it might be worth more or less. But, without going into details, relative to their worth, it’s expensive to sell a bond.

Add to that, there is a significant discount when buying a bunch of bonds as compared to buying only one. Typically, I like seeing individual investors buying bonds in $10,000 chunks (not a technical term). For diversity, I’d like to see them buy 10 or more different bond issuers. That’s $100,000 for a “starter” position in bonds. (Note:  you can start much smaller, but fees will go up and/or diversification will go down accordingly.)

Enter the bond fund.

Just like a stock fund, a bond fund allows you to buy tiny dollar values of bonds, makes selling them later a lot easier, giving you tremendous diversification;  and on top of all that, someone else gets stuck trying to figure out what bonds to buy. With a bond fund, it seems, you get to have it all.

Not quite.

While our example from our last column showed the problems with selling a bond before it matures, you do get two very nice features with owning a bond directly. First, it does have a maturity date. So, assuming the company is still around, when that 20 years is over, you’ll get your money back—no less. And in the meantime, you will get a steady stream of income from the interest the bond pays across those years.

With a bond fund, there is no “maturity” …it keeps going and going. The fund company is continually buying and selling bonds inside the fund. Yes, they are trying to make you money (it helps keep them in business), but you don’t know that on a certain date if your investment will be worth what you put into it. Nor do you know what your interest payments from the fund will be next quarter, let alone next year.

This is not necessarily bad, as interest payments might go up and the value of your investment might likewise go up. But if you have to know for sure what you will earn each month and what your investment will be worth in 5, 10, 20 years, a bond fund might not be for you.

All that said, for the vast majority of people, certainly most who invest less than $100,000 in bonds, a bond fund will make the most sense. The possible exception to this are those who want the rock-solid (we hope) guarantee of US Government bonds. There, holding individual bonds is more doable. Heck, you can buy them from the government online.

One note before I close this bond series: For reasons I won’t go into here, generally I do not like indexed bond mutual funds or their ETF cousins. Here again, I don’t have a problem with indexing Government bonds. If you care to know why ask me sometime.

Gary Silverman, CFP® is the founder of Personal Money Planning, LLC, a Wichita Falls retirement planning and investment management firm and author of Real World Investing.