Should I Be Buying Bond Funds Now?
Last week, we covered the benefits and important considerations before purchasing an individual bond. This week, we take a look at bond funds.
Not all bond funds are created equal. Specific to the bond funds that we use in our core portfolios, they have the following benefits:
Professional management and economies of scale which lead to low costs.
Active risk management on interest rates, credit and default risk.
Access through low minimums.
Targets the highest yields on all yield curves and currencies.
Play an important role a total portfolio as a volatility dampener.
However, there are some things it cannot do very well:
Liability matching.
Matured bonds are systematically rolled over (new bonds are being bought with the proceeds). As such, there is no maturity with bond funds.
There are investors that prefer buying individual bonds as they perceive its ability not to lose value and have a guaranteed maturity compared to bond funds. But are there more cons than pros? Let’s look at a simple illustration below.
For example, an individual 5-year bond and a bond fund both start with a value of $250,000 and both have a duration of 5 years. If interest rates started at 1% and rose suddenly to 4%, the values of both the individual bond and bond fund will fall approximately 15%.
Whether you held the individual five year bond or the bond fund, both will have the same market value. However, the bond fund can dynamically target bonds on the yield curve that have the highest yield while the individual 5-year bond is only able to roll down the yield curve as it becomes a four-year bond, a three-year bond so on and so forth until maturity.
The bond fund creates more wealth as it is able to target the highest yielding part of the yield curve, this effect compounded over an investor’s lifetime can be substantial. Whilst the bond fund has no specific maturity, if the investor requires the money, the bond fund can be sold at any point in time.
Unless you have a specific need to meet and match your liabilities, a bond fund will be the best way for you to maximise your wealth as well as offer more flexibility in terms of reallocation and liquidity.
In the same way that you would not attempt a high risk activity such as sky-diving without professional supervision, investors can benefit greatly by relying on an adviser — having the peace of mind knowing that their plan is in the hands of a professional.
If you are not sure if you should be holding direct bonds or bond funds and would like a better understanding, click here to schedule a chat with us. (Our 30-minute exploratory meeting is complimentary - either Zoom or In-Person)