Farrell: A primer on bonds, interest rates and bond ladders
- Article by: CHRIS FARRELL
- January 18, 2014 - 4:53 PM
Q: What are the benefits of owning a bond fund or individual bonds? How does one determine if Treasury, municipal, corporate, inflation or international bonds are the best fit for your portfolio? If we want to buy a ladder of individual bonds, how do we find someone to help us and how much would we expect that to cost?
A: This seems like a fairly straightforward question. But opinions are sharply divided on the merits of bond index funds, actively managed bond funds, owning individual bonds and bond ladders. Each offers a mix of advantages and disadvantages.
What’s more, it’s important to put fixed-income securities in the right account. For instance, municipal bonds shouldn’t go into tax-sheltered retirement plans since you’re wasting the tax-advantaged nature of the investment. In an IRA you can’t purchase new issues of Treasury Inflation Protected Securities (TIPS) directly from the government. You have to buy them in the secondary market (usually a mistake) or through a fund or exchange-traded fund (a better move).
When it comes to investing, including fixed-income securities, the lens I use puts a premium on convenience, simplicity, low cost and diversification. I stick with the high-quality end of the market where credit risk is less of a concern. My favorite fixed-income securities for long-term portfolios are TIPS and I Bonds (inflation-protected savings bonds). These default-free securities are designed to protect your long-term savings from inflation with some extra interest earnings thrown in. Although I’m an optimist on the inflation front, it’s critical to own creditworthy investments that protect against the erosion of your savings via inflation. TIPS are good for retirement portfolios. I Bonds should be held outside any retirement portfolio.
I’m a fan of bond funds. A major benefit of bond funds — indexed or actively managed — is the ease of reinvesting interest payments so that your money compounds over time. A major drawback to any bond fund is that the payout is uncertain since there is no set maturity date. In practice, that means the net asset value of the fund will fluctuate, depending on the interest-rate environment, falling when rates rise and rising when rates tumble. Among bond funds, I like index funds with their razor-thin fees and good diversification. Although there is no end date with bond funds, you can easily choose which segments of the market to invest in since fund managers typically offer short-term index funds (five-year fixed-income securities and less), medium-term index funds (five to 10 years) and long-term funds (10 years and more).
A big attraction of owning individual bonds is certainty. You know how much you’ll earn if you hold the bond until maturity.
A bond ladder is a popular way to deal with the problem of interest-rate risk. The idea is to invest in fixed-income securities with different maturities and, therefore, different interest rates. For example, if you had $50,000 you could plunk down $10,000 each to buy Treasuries with various maturities ranging from one year to 10 years. If rates go up, you have some short-term debts maturing soon that you can reinvest at higher rates.
Many mutual fund and brokerage firms offer bond ladder programs. I prefer the bond index fund route, especially in retirement portfolios.
Chris Farrell is economics editor for “Marketplace Money.” His e-mail is firstname.lastname@example.org.
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