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Isaiah Adams
Isaiah Adams

Buying Bonds Vs Bond Funds

The primary risk with bonds is the potential for the issuing entity's default. You can get some help from credit rating agencies, such as Standard & Poor's, by reviewing their ratings. (For S&P, AAA is the highest rating, and D is the lowest rating.) However, credit ratings are not guarantees about the issuing entity's financial soundness.

buying bonds vs bond funds

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Series I savings bonds protect you from inflation. With an I bond, you earn both a fixed rate of interest and a rate that changes with inflation. Twice a year, we set the inflation rate for the next 6 months.

Your luck happened to be really bad and immediately after buying this bond, the CPI showed unexpected inflation and interest rates shot up. Seconds after buying this bond, the same bond is now yielding 6 percent. A new bond would now be paying $1,060 in a year. The bond you bought, however, is giving you back only $1,050, so now the value of your bond is calculated as follows:

Because interest rates went up by 1 percent, the value of your bond dropped by $9.43 or 0.94 percent. If you keep the bond for the entire year, you'll get $1,050 back and won't have the loss, right? Well, not so fast. Remember that the new bond is paying 6 percent, so you missed out on buying the $1,000 bond that would have paid $1,060, or an additional $10.00. So, holding onto the bond has an opportunity cost of:

An additional benefit of bond funds - liquidityBut bonds can be sold, right? I have no argument with that, though they are still not as liquid as an open-ended no-load bond fund. A no-load bond fund can be sold without a cost. Even a bond ETF can be sold at a minimal cost and the bid-ask spread is usually less than 0.05 percent, or five basis points.

Individual bonds, on the other hand, can have bid-ask spreads of fifty to five hundred basis points. No, this isn't a typo. You will, unfortunately, have no idea that you are paying these hefty fees to the market maker. This is one of the financial industry's dirty little secrets. Okay, maybe not so little.

My adviceLow cost bond index funds provide professional management with very low costs. In return for paying as little as 14 basis points (0.14%) annually, you get diversification and liquidity. This is a bargain, in my book. Some good high quality bond funds include a Total Bond Index fund from iShares or Vanguard.

Bond prices move in the opposite direction of interest rates while bond fund prices are sensitive to interest rates. Bond fund managers constantly buy and sell the underlying bonds held in the fund so the change in bond prices will change the NAV of the fund.

- Paid if shares are sold for profit - Paid when a fund manager sells bonds for profit (managers buy and sell bonds during the year, capital gains or losses are passed to investors) Investors may be liable for tax on imbedded gains even if they have not enjoyed the returns.

Yields on high-grade corporate bonds appear compelling. However, from a credit-spread perspective, we see too little compensation above risk-free Treasuries given the late-cycle risks in the market.Spreads do have room to widen, but a renewed investor appetite for higher-quality bonds may put a ceiling on how wide spreads could drift.

We expect tighter financial conditions to crimp corporate finances broadly. Rising stars (company upgrades from high yield to investment grade) outpaced fallen angels (downgrades from investment grade) by a wide margin over the past two years. Still, we expect more downgrades in 2023, especially in lower-quality cyclical segments. The depth and duration of any market downturn would determine the impact, but we see that most companies are prepared for a normal recession.Within a more modest allocation to investment grade, we see value in higher-quality issues within financials, utilities, and noncyclical industries. We prefer noncyclical companies because they tend to retain earnings resilience during economic downturns. Though bonds of cyclical companies can have higher spreads at challenging times, they currently trade in line with noncyclicals, another reason we see noncyclicals as the better bet.

Some stabilization in U.S. Treasury rates could be a catalyst for emerging markets (EM) inflows. We saw that occur over the last few months of 2022 during a period of light EM bond issuance, and historical data suggest an improving trend. That should bolster the supply/demand picture for EM, as we see another year of net negative supply.Our more favorable view on the sector late last year benefited from the 125 bps rally in spreads, but it leaves us less constructive today with valuations no longer cheap.Country fundamentals are broadly stable, but we anticipate significant credit differentiation as the global economy slows down in 2023. This will create opportunities for relative value and active management.Our preference for higher-quality bonds is balanced by the fact that spreads in investment-grade EM are very tight and additional borrowing is likely. The high-yield segment of EM offers much more compelling valuations but is also the most vulnerable to further economic disruption.We see 2023 as a market where the best strategy is to be defensive but agile, with enough liquidity to act on new opportunities that arise.

After all, if individual investors and advisors had allocations to municipals with yields barely over 1% at the beginning of 2022, then they should now salivate at the prospect of yields exceeding 3% (before adjusting for tax benefits). With tax-loss harvesting opportunities ending, we expect that high-earning investors will be motivated to increase their tax-exempt holdings over time. Higher yields not only mean greater income but also greater portfolio stability if a deeper recession transpires.The tax-exempt primary bond market was busy at the start of 2022, but higher rates stunted the pace of issuance later on, consistent with our forecast. The supply picture going forward is uncertain, as usual, yet future issuance will likely remain subdued as the cost of borrowing is higher and municipal balance sheets are still flush with cash from pandemic-era stimulus.Both inflows and lower supply should support municipal valuations in 2023. The quick 4.1% rally in the fourth quarter indicated that these effects are underway. The rebound may lure more investors back with attractive yields and reduce the possibility of negative returns this year. With tax-equivalent yields of 6.0% (or meaningfully higher for residents in high-tax states who invest in corresponding state funds), municipals offer great value compared with other fixed income sectors and potentially even equities, especially with the odds of a recession increasing.

Note: Chart represents change in yields above U.S. Treasuries of similar duration for U.S. corporate bonds, and the difference in yields between AAA and BBB rated segments of the municipal market.

Mr. Alwine was previously head of Vanguard's Municipal Group. There, he led a team of 30 investment professionals who managed over $90 billion in client assets across 12 municipal bond funds. He has served in multiple roles throughout his career in the Fixed Income Group. His experience includes trading, portfolio management, and credit research. Mr. Alwine's portfolio management experience spans both taxable and municipal markets, as well as active and index funds. He is also a member of the investment committee at Vanguard that is responsible for developing macro strategies for the funds.

Individual bonds are available for purchase, or you can choose to invest in bond mutual funds or exchange traded funds (ETFs). You can also acquire government bonds directly from the U.S. Treasury, which allows you to avoid the fees associated with buying through a broker.

An alternative to fixed-return bonds is U.S. government-issued Series I bonds, which help protect your investment by adjusting for inflation. The yields on these bonds rise and fall along with the rate of inflation.

Investors looking to diversify their portfolio may decide to put a set percentage of their money in bonds, since they generally carry lower risk than stocks. As retirement draws nearer, some choose to invest more heavily in bonds in hopes of receiving a steady return with little chance of losing money.

Treasury bonds and U.S. savings bonds are backed by the federal government. While the same is not true for alternatives such as corporate bonds, you can help minimize your chances of losing money by choosing bonds that have been rated investment grade by the credit-rating agencies.

The funds in most CDs cannot be accessed before the CD matures without your being subjected to an early withdrawal penalty. While bonds also carry a maturity date, you may be able to sell them on the secondary market before that date arrives.

Bond mutual funds were net buyers of bonds in October. As Figure 2 shows, despite outflows, all different types of bond funds were buying on net. For example, although investment grade and multisector bond mutual funds (Panel A) had $28 billion in outflows in October, these funds collectively purchased, on net, $12 billion in corporate bonds and $4 billion in US government bonds. Municipal bond funds (Panel B) also were net buyers of municipal bonds despite outflows. High-yield bond mutual funds (Panel C), which are often scrutinized by regulators and the financial press, purchased, on net, a small amount of corporate bonds, and their holdings of government bonds (not shown) were essentially unchanged.

Bond fund managers have many ways to meet redemption requests other than selling bonds. For example, in any given month, mutual funds receive cash as the bonds they hold either pay interest or mature. These cash sources often can fulfill the vast majority of redemption requests. In addition, bond fund managers hold short-term assets or use derivatives to manage their liquidity and prepare to meet redemptions. 041b061a72


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