With the probability of interest rates going up, some investors might think that it is time to buy individual bonds instead of bond funds.
Some investors rationalize that if they own individual bonds, they can simply hold them to maturity because though the price of their bond will vary from day to day, at least they can be reasonably certain that they will receive the face (par) value of their bond when it matures. On the other hand, if they own a bond fund and bond prices decline, shareholders may jump ship, forcing the fund manager to sell bonds at a loss to meet redemptions.
For most investors, funds are a far more cost-effective way of owning bonds and navigating changing markets. Funds offer greater diversification, flexibility and opportunity than individual bonds, and these benefits are a tremendous advantage in uncertain markets.
Those who are concerned about what will happen when rates rise should consider these four important advantages of bond funds.
When investors own bond funds, their holdings are spread out over hundreds or even thousands of individual issues. This diversification reduces credit or default risk.
Defaults have been low, but when rates rise, defaults tend to rise, too.
Most individual bond investors aren't broadly diversified. Most hold fewer than 10 bonds in their portfolio.
This may not seem very risky when defaults are few and far between, but if the economy falters and more companies start to default on their debt, there could be far greater danger in a concentrated portfolio of individual bonds.
Remember Enron, whose bonds were rated investment-grade until just days before the company declared bankruptcy in 2001? Many funds that held Enron in their portfolios still posted gains that year, thanks to their many other positions.
But individual investors who thought that they would just hold Enron debt to maturity learned the hard way that not every bond matures.
Funds offer diversification even for investors with modest portfolios. Investors can own a diversified portfolio of bond funds with a few thousand dollars, while it takes a lot of money -- upwards of $1 million -- to own a truly diversified portfolio of individual bonds.
2. Expert research
Mutual fund companies really earn their fees by doing in-depth research on companies before they buy their bonds. And this is particularly valuable with lower-quality bonds issued by smaller companies, which often don't pay to have the ratings agencies evaluate their debt.
Individual investors could use rating agencies and buy a bond rated Aaa by Moody or AAA by Standard & Poor's, but these ratings may not always be reliable, as the aftermath of the debt crisis of 2008 made painfully apparent.
Bond funds also trade across many brokers and have access to many bonds unavailable to retail investors.
3. More investment opportunities
Different areas of the bond market can really add value at times, including periods of rising rates. But buying individual bank loans, high-yield bonds or emerging-market bonds, for example, can be risky and costly.
Dollar-hedged foreign-bond funds such as Vanguard Total International Bond have done well lately, but this strategy would be difficult and expensive to implement on one's own with individual bonds.
Floating-rate funds, which invest in bank loans, are another example. These funds can be appealing when rates are rising because they own pools of bank loans made to companies, and the rates on those loans adjust as rates change in the marketplace. Bank loans are best accessed through mutual funds such as Fidelity Floating Rate High Income, a fund that has been doing well recently.
4. Change a portfolio easily and efficiently
No one knows for sure how rates might affect the bond market, and funds make it easy for to adapt as markets change. Say that an investor wants to dial down rate risk by lowering the duration of a bond portfolio.
If that investor owned bond funds, he or she would simply sell the longer-duration funds and buy lower-duration funds. The investor would get that day's price or net asset value for the shares and might be able to trade funds without paying transaction fees.
Re-shuffling a portfolio of individual bonds to lower average duration, however, would be costly. The mark-up on bonds charged by broker-dealers typically runs between 0.5% to 1.0%, which will affect investors when they buy a bond and when they sell it.
This spread will be particularly wide if the investor is dealing with relatively small dollar amounts of less than $100,000 trades or if the investor is trading in a particularly volatile market. This hidden cost is in addition to any transaction fee that the broker might charge.
All told, the investors could give up several months' worth of interest in costs, substantially eating into returns.
Once an investor recognizes the benefits of bond funds, the next question is which bond funds and exchange-traded funds should be purchased? Consider a fund's risk and then look for funds with good recent returns because these funds tend to continue to do well in the coming months or even years.
Here are three funds to consider:
Fidelity Floating Rate High Income (FFRHX - Get Report) : Floating-rate funds were a good option when rates rose modestly before the 2008 credit crisis, but they do have credit risk, because they typically invest in low-quality bonds or bank loans made to companies whose credit quality is rated below-investment-grade. As with foreign-bond funds, use these funds sparingly.
iShares Core Total U.S. Bond (AGG - Get Report) : This has done better than many other intermediate-term funds over the past six and 12 months, and because it is an ETF, investors can easily move on if rates rise and they want to invest in funds that have a lower duration.
Vanguard Total International Bond (BNDX - Get Report) : Although rates are expected to rise in the United States, other countries are cutting rates, and world bond funds that are hedged back to the strong dollar, such as this fund, have done well this year. But foreign-bond funds can be risky so don't invest too much in these funds.
One additional fund to consider is PowerShares Preferred Stock (PWX)
Preferred stocks combine the bond-like feature of paying a fixed dividend with some of the appreciation potential of equity. Preferreds are less senior securities, but they offer a competitive yield compared with high-yield bonds and held up significantly better in the recent high-yield rout.
Although investors should limit their exposure to these funds, they can offer additional diversification and usually have less rate risk.