Individual bonds, of bond ETF’s that is the question… Many people believe that by investing in an ETF you are getting all the gains, with very little of the work. But with current market conditions, it just isn’t that simple. So I’m here to tell you which is better… Bonds, or bond ETF’s.
Investing in both individual bonds and bond ETF’s is a good strategy to reduce your portfolios risk. Obviously investing in bond ETF’s requires less work and research, so might be more suited towards a passive trader. However investing in individual bonds can yield higher returns.
The bond market is considered to be one of the safest investments, so we’ll look briefly why that is, but you should be aware a lot of money can be lost in the bond market. I produced an article looking at the best bond investments you can make, most of these were bond ETF’s, however I do believe that for experienced investors, more money can be made through individual bonds.
Why are Bonds a Good Investment?
Bonds are one of the most important parts of a long term investment portfolio.
For decades, investors have prioritised stocks as the number one vehicle for long term saving, but with two major stock market crashes occurring thus far in the 21st century, bonds help investors reduce exposure to risk.
Bonds provide investors with a fixed income while also appreciating in value inline with the overall economy. Bonds tend to offer the highest and most reliable cash streams, even at times of low interest rates. Investments in bonds of the highest quality can produces income for over 20 years.
Along with being tax advantageous, bonds also increase diversity across your portfolio. Because they have low volatility, bonds can reduce your portfolios risk. Whether you choose investment grade Treasury bonds, of high yield corporate bonds, as long as they are rated BBB or above, you can preserve your capital during times of market decline.
Bonds don’t usually make for interesting conversation at dinner parties, but if you think that’s because they don’t make money… You are wrong!
Investing in Individual Bonds
Bonds are debt obligations issued by entities such as, the Government, or large corporations. When you buy a bond, you are basically lending your money to the entity for an agreed period of time.
In exchange for your loan, the entity will pay you regular amounts of interest until the agreed period ends, this end date is also known as the maturity date.
On the maturity date, you will receive your initial investment back, and the interest you’ve been paid during the term of the loan is your profit. The fact you receive your initial investment back once the bond has matured makes ideal for anyone looking to save money long term.
How Individual Bonds Work
An investor will buy a bond, then receive a fixed income from the bond until it has reached maturity, then the investor will receive 100% of their initial investment once the bond has matured.
The specific time period of a bond can be anywhere between 3 months, too well over 20 years.
Individual bonds give the investor a ‘no loss of principal’ investment as they get back the initial investment. However, this is only the case if the investor holds the bond until maturity, and the company doesn’t fall into extreme financial struggle.
The bonds price will fluctuate during the time the investor is holding it, so some savvy investors like to treat this as bond appreciation. During the hold period of a bond, if the price has gone up, you can decide whether or not you want to continue to hold it, or sell for a profit.
Normally investors will only sell a bond if the new price yields more profit than they stand to gain through interest.
When Should you Buy Individual Bonds?
As always, I try to avoid terms like ‘time the market’ because it is very difficult too. But with fixed income investments such as bonds, you can make calculated decisions by watching interest rates.
Bond prices typically move the opposite way to interest rates, so when interest rates fall, bonds become more expensive.
Over the last 40 years, we have seen interest rates generally decline. This has created quite a positive environment for bondholders, as investors were able to anticipate interest rates falling, making their bonds more valuable.
So… When interest rates are expected to rise, it might be a good time to consider adding individual bonds to your portfolio.
Investing in Bond ETF’s
Bond ETF’s are a type of exchange-traded-fund that exclusively invests in bonds. They are very similar to bond mutual funds, but they have considerably lower fees.
Typical bond ETF strategies are:
- US Treasury investments.
- Investment grade corporate bonds.
- High yield bond portfolios.
- Index bond ETF’s.
- Industry specific holdings.
Bond ETF’s are passively managed just like stock ETF’s. This helps reduce risk and volatility by adding liquidity and diversity through times of market decline.
Just like individual bonds, bond ETF’s offer fixed income in way of interest, but are more likely to appreciate in value, making them desirable among value investors.
How Bond ETF’s Work
Just like individual bonds, bond ETF’s offer investors regular interest payments. Normally these are once every 6 months, however because of the wide range of investments within the ETF, most offer monthly payments.
Bonds in the ETF are constantly changing and do not expire. Instead of holding bonds until maturity, the ETF managers sell the asset as they mature, or exit the target age range of the fund. This could mean bonds are sold at a lower price than purchased.
Because the bond market has a low liquidity, it is especially hard for the fund managers to closely track the underlying index the ETF follows. Corporate bond ETF’s tend to have more of an issue with liquidity, whereas Government bonds are more liquid, and therefore easier to track.
Bond ETF’s unlike individual bonds do not offer the investor a no loss of principal. If the overall bond market dips, and bond prices fall, the investor will see a decline in their principal investment. This is because the ETF no longer holds the same amount of value.
When Should you Buy Bond ETF’s?
You want to invest in bond ETF’s when the bond price is increasing. Because bond ETF’s buy and sell bonds quite frequently, you want to maximise your exposure to gains from both interest payments, and asset appreciation.
When bond prices are increasing it drives the price of the bond ETF up, meaning you will building your investments value.
Individual Bonds vs Bond ETF’s
Here is a quick comparison of both ways to invest in bonds:
|Individual Bonds||Bond ETF|
|Management||Investors manage their own portfolio via online brokers.||Professionally managed by licensed companies.|
|Maturity Date||Set maturity dates, but bonds can be sold prior to maturity.||Bonds are constantly bought and sold with almost none being held till maturity.|
|Income||Fixed semi-annual payments of interest.||Fluctuating monthly distributions.|
|Market Risk||If all bonds are held till maturity, there is no market risk.||Market conditions affect the value of the ETF, capital is at risk.|
|Liquidity||Individual bonds are not very liquid as there is no typical secondary market for bonds prior to maturity.||You can buy and sell shares in the bond ETF very easily, this makes it very liquid.|
|Diversification||To be considered diverse, investors much purchase many bonds from multiple issuers. This can be very expensive.||Bond ETF’s are very diverse, you can usually see all holdings on the funds website.|
|Credit Risk||Investment grade bonds have the lowest risk of default.||Depending on the quality of the underlying investments, ETF’s can be both high & low risk. Higher diversification can mitigate that risk.|
|Cost||Some brokers will charge fees upon sale of a bond, or they may have a high spread. Brokers such as eToro boast about their 0% commission.||ETF’s have annual fees to cover management costs, they also may charge commission on distributions as a cost of investing in the fund.|
So… Which is Better?
These are the 4 factors you should consider before investing in either a bond, or a bond ETF. Based on your experience in the market, your goals, and your risk tolerance, you should be able to learn from these factors, which investment vehicle is best for you.
Based on Risk:
The risk associated with bonds is very low.
When investing in individual bonds with the intent to hold them till maturity, your risk is almost zero. Investment grade and Treasury bonds are among the highest rated investments you can make in terms of safety. The only way you would lose money is if the issuer defaulted on a payment, or the company went bankrupt.
As long as you stick to high quality individual bonds you will have minimal risk.
Bond ETF’s however can result in a lose of capital. Because they are not fixed income investments, your initial capital is at risk. If the ETF has a string of bad picks, the value of the fund will go down, meaning your investment will go down.
If interest rates fluctuate while you hold an individual bond, your investment has not changed value because you are invested in a no loss of principal agreement. However if the same were to happen but you invested in a bond ETF, the value of your shares could decrease, causing you to lose money.
Individual bonds are the safer investment.
Based on Cost:
Other than small brokerage fees, which you can avoid either by going direct to the issuer, or by choosing one of the online brokers out there, individual bonds don’t cost anything other than the market price.
With ETF’s you are paying an annual fee to keep your money in there, and commission on any distributions which goes towards paying the managers of the fund.
Again… Individual bonds are the cheaper option.
Based on Passivity:
This one you can probably guess… Put your money in a fund and let it ride. In a bond ETF you don’t have to do anything once your money is invested, however I would recommend keeping an eye on the holdings inside the fund, and the index it follows.
Not to say investing in individual bonds is time consuming, but all the pressure to find a good investment, then to keep track of the value, and then decide whether or not to sell. It can be stressful.
If you want to invest in bonds but don’t have the necessary skill set, or the time to really research into the market, bond ETF’s are the way to go.
For an easy ride pick a bond ETF.
Based on Potential Gains:
This depends on the overall direction of the market, so I’ll go over a couple of examples.
When interest rates are high:
When interest rates are high, bond ETF’s are more desirable.
Because they offer a fixed income, your best bet is to buy shares in a bond ETF. If you invest in a good ETF, you will not only be able to draw regular distributions…
But if interest rates were to decrease in the next year, not only have you been drawing fixed income for that period, your shares in the bond ETF are now more valuable because, as interest rates fall, bond value rises.
The potential gains when interest rates are high are better in a bond ETF.
When interest rates are low:
Individual bonds are more valuable when interest rates are low.
If you are looking to invest in a bond and hold it to maturity, invest when interest rates are low. This will give you the best chance to outpace inflation, and grow your money.
When interest rates are low, bond ETF’s buy and sell bonds at huge premiums which can devalue the assets held in the fund. So, buying and holding single bonds will keep your money safe and increase your portfolio value.
The potential gains when interest rates are low are better when buying & holding in individual bonds.
As someone who likes to do very little work, I am all for bond ETF’s. But as we’ve seen, for the most part, you can make more money investing in individual bonds.
Most investors look to bonds as a way to lower risk and increase diversity across their portfolio. So for stock investors, I would stick to bond ETF’s.
Mainstream bond investors should prioritise single bonds as they can yield massive gains if invested in wisely. Bonds are a great way to grow your retirement fund, and save for the long term. With very little risk involved, I personally have a retirement account of which individual bonds play a big part.
My number 1 tip for investing in bonds is… If you’re under 50 stick to ETF’s, and if you’re over 50, go for individual bonds.