If Interest Rates Rise, Bonds or Bond Funds?

EDITOR'S NOTE: This article was originally published in the January 2011 issue of Kiplinger's Retirement Report. To subscribe, click here.

The portfolio of every investor nearing or in retirement should be chock-full of bonds. But many individuals who are choosing fixed-income investments may ask this question: Should I buy individual bonds or bond mutual funds?

For do-it-yourself investors, bond mutual funds have long been considered one of the safest investments. The popularity of bond funds soared in the past two years as investors sought to avoid the market fluctuations that decimated stock portfolios. During the first ten months of 2010, $267 billion poured into bond mutual funds, while investors pulled out $30 billion from stock funds, according to the Investment Company Institute.

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And bond fund investors reaped rewards: The year-to-date return for intermediate bond funds was 7.6% as of early December. But fund investors could now have some reason for worry. Interest rates, and bond yields, are close to their lowest levels ever. That means bond values are near their highest ever. (Bond prices rise when interest rates drop, and vice versa.)

If interest rates rise, the value of bond funds will decline -- and investors can lose money. "With the run-up in prices and the run-down in yields, we are at the tail end of a bond bull market," says Marilyn Cohen, a fixed-income expert and chief of investment strategy at Envision Capital Management, in Los Angeles.

Toward the end of 2010, rates were creeping up after falling during much of the year. On December 9, the rate of the ten-year Treasury note was 3.23%, up from 2.41% to 2.59% in the early fall. That's despite the Federal Reserve's attempt to keep rates low by buying long-term Treasury bonds.

But interest rates won't rise like gangbusters overnight. You do have time to study your options, which could include a portfolio that contains both funds and individual bonds.

Bond funds have advantages over individual bonds. Professional managers save time-pressed investors from having to investigate price, creditworthiness, maturity, coupon rate and other factors that are important to bond investing.

Funds also provide instant diversification. Corporate and municipal bond funds often own hundreds of bonds. If a bond in your fund defaults, you'd barely feel it. But if you hold individual bonds, "a default in a portfolio of ten or 20 bonds could have a significant impact on your ability to retire," says Paul Jacobs, a certified financial planner with Palisades Hudson Financial Group, in Atlanta.

Retirees who need liquidity can redeem fund shares at any time, although they could end up selling from a depressed asset if the fund's value declines. Of course, you can sell individual bonds before maturity, but you run the risk of selling at a price that's less than the original investment. "The only time when I would recommend owning bonds is if you're confident you're not going to sell them before they mature," says Jacobs.

If investors need income, the fund can distribute monthly dividends. But the payments will fluctuate because bonds in the fund are constantly being bought and sold for different prices. "You could consider a bond fund if you're willing to tolerate some fluctuation in monthly income and in the monthly value of your investment for the trade-off of professional management," says Robert Williams, director of income planning at Charles Schwab.

Bond funds are often the fixed-income choice for investors who may not need immediate income but are looking for longer-term growth. If interest rates rise, Williams says, the drop in the fund's value will likely be temporary. As bond prices fall, fund managers will buy new bonds with higher yields. "If a bond fund investor can focus on the longer term, a rising-rate environment can lead to higher income for the fund," Williams says. However, he notes, that if rates rise steadily over time, it could take a while for the increased income to offset the capital losses.

The interest-rate uncertainty makes it all the more important for fund buyers to first check the fund's "duration." The duration, which is measured in years, is a gauge of the fund's sensitivity to interest-rate changes. For instance, a fund with an average duration of 4.5 will fall in value 4.5% if rates rise by 1%. The opposite is true as well. If interest rates drop by 1%, the fund's value will increase by 4.5%. (You can find a bond fund's duration at Morningstar.com. Go to the fund's page and look under "Style Map.")

Because of the specter of rising rates, Jacobs is investing in funds with the shortest durations. These funds invest in bonds with maturities of less than a year. "If interest rates spike, the fund will go down in the short term, but it won't take long to break even, and then the fund will benefit from higher rates," he says. Short-term bond funds have lower yields than longer-term funds, he says, "but the risks in the bond market are too great to reach for yield."

Williams says that the recent rate rise "has been more significant for bonds with longer maturities, over ten years or so. This is also where there is more risk that prices fall if rates rise." He prefers intermediate-range bond funds, which have durations of three to five years. If investors don't need their principal back immediately, these funds provide a good balance between income and safety. "The fund will be generating a nice income in five years," he says.

The Case for Individual Bonds

Retirees who need a predictable monthly income stream should opt for individual bonds rather than bond funds. Individual bonds offer regular, fixed payments. Unless there is a default, your principal will be returned when your bond matures.

In a risky rate environment, Cohen says that investors should look to individual bonds. "If you buy individual bonds, even at low interest rates, you will get your money back if the company stays liquid," she says. "With a bond fund, that is not true."

Cohen worries that if rates spike or there's a big default, investors will start selling their bond funds. That will lead to more selling, and fund managers will need to sell bonds at lower prices to raise cash to pay off departing investors. During the two weeks ending November 24, as rates started to rise, investors pulled $6 billion from bond funds.

Cohen offers practical advice for do-it-yourself bond investors in her new book, Bonds Now! Making Money in the New Fixed Income Landscape (Wiley, $30). "A bond fund manager will tell you how difficult it is to manage your own bond portfolio," she says. "It is not, if you're willing to do some work."

On the top of her list: Diversify your bond holdings. No issuer should account for more than 3% to 5% of an entire bond portfolio. That means you need a minimum of 20 different issues. Limit holdings of any single industry for corporate bonds, and of any geographic area for municipal bonds, to 15%. Only buy non-callable investment-grade corporate bonds, very safe municipal bonds and Treasuries.

Also, diversify your maturity years. You can protect against rate fluctuations by staggering maturities in a bond ladder. If rates rise (and bond values decline), you won't be stuck forever. When a bond in the ladder matures, you take the proceeds and buy a new bond with a higher yield for a lesser price.

Cohen also suggests that you use at least two brokers. You figure out which bond fits your portfolio, and ask the broker to get you a price quote. Then log into www.investinginbonds.com or www.emma.msrb.org, and type in the CUSIP number. Up comes a screen that shows the bond's trading history.

For instance, on December 2, a bond issued by Merrill Lynch was being sold at prices ranging from 102.587 to 104.598. If your broker offers to buy you the bond in the 104 range, make a counteroffer in the lower range. "You should negotiate with your broker," Cohen says. "Think of it as a Turkish bazaar."

The same goes for trading online. Bonds at discount broker sites are not owned by the firms, but are fed in from broker-dealers. Review the trading history on the bond Web sites and bid the price you're willing to pay, Cohen says.

You can combine strategies. If you're a fund investor who wants to invest in Treasury inflation-protected securities, buy the TIPS directly from the Treasury (www.treasurydirect.gov). Investors who usually stick with individual bonds may turn to funds for niche investing, such as emerging-markets bond funds.

So should you batten down the hatches to prepare for a rising-rate storm? If you're a fund investor, you can replace some of your bond fund holdings with individual bonds that have shorter maturities. Don't move your entire bond portfolio at once. Switch a chunk at a time.

If you want to stick with funds, consider moving from long-term bond funds into funds with shorter durations. Although Williams recommends intermediate-term funds for any interest-rate environment, he suggests a move to shorter-term funds if "you think you'll sell if you see the price of your fund drop."