NEW YORK ( TheStreet) -- Plenty of financial advisers are wary of bond exchange-traded funds and mutual funds.
The problem is that bond ETFs and mutual funds sink when interest rates rise. The drop could be particularly steep in this cycle, because bonds have reached sky-high levels after rallying for years.
If rates rise by one percentage point next year, iShares Barclays Aggregate Bond ETF (AGG) could fall by more than 4%.
To avoid trouble, many advisers suggest buying individual bonds. While individual bonds can rise and fall, they usually repay principal on maturity dates. That makes individual bonds sound choices for investors who need to have a certain amount of money on a particular date.Say you plan to buy a house in 2015. You could buy a municipal bond that matures on the date the money is due.
But individual bonds can be risky. If a bond defaults, the investor could lose some or all of the principal. And bonds can be expensive to trade for investors with limited budgets. That's why many retail investors prefer funds that offer broad diversification and modest prices. Now ETFs have appeared that offer some of the best features of funds and individual securities. The ETFs invest in securities that will mature in a certain year, such as 2014. That way, investors have a good idea of what their returns will be. And because the defined-maturity funds hold broad portfolios, they offer diversification. Entrants in the field include iShares, which offers a line of municipal ETFs, including iShares 2016 S&P AMT-Free Municipal ETF (MUAE). Guggenheim offers ETFs that hold high-yield and investment-grade corporate bonds, including Guggenheim BulletShares 2015 High Yield Corporate Bond (BSJF). To appreciate the advantages of the new funds, consider an investor who must pay college tuition in five years. To cover the tab, the parent could invest in Treasuries. Those provide security, but five-year Treasuries currently yield only 0.61%. For a richer payout, you could buy Guggenheim BulletShares 2017 Corporate Bond (BSCH), which yields 1.67%. Corporate bonds can default. But Guggenheim holds investment-grade issues that are likely to survive for the next five years. If a few issues do go bad, the returns should still be solid because the fund holds 186 different securities. Those who can tolerate more risk can get a yield of 5.21% with Guggenheim BulletShares 2017 High Yield Corporate Bond (BSJH), a fund that holds 64 bonds.