Here’s How You Build a Bond Portfolio That Works

By: Jared_Dillian

When you invest in bonds, do you buy individual bonds or bond funds?

• Unless you have a lot of money, you should probably buy bond funds.

• And even if you do have a lot of money, you should probably buy bond funds.

Let me explain.

Little Diversification

I have owned individual bonds in the past, for speculative reasons. If you have a brokerage account, they are not that hard to buy.

But individual bonds are not as liquid as stocks. The bid-ask spread (a measure of market liquidity) on a typical bond could be two points wide for a retail client. That is pretty illiquid, so it’s not the type of thing you day-trade.

Short-dated high-grade corporates will be a bit tighter, but it’s not .01 wide like a stock.

If you buy individual bonds, you are probably holding them to maturity. This is especially true in the case of munis, most of which are very illiquid.

I will say that owning individual bonds is fun. It is cool when the sem-iannual interest payment hits your account.

But the big problem with owning individual bonds is that it is hard to achieve diversification unless you have a lot of money.

You can achieve diversification with 20-30 stocks. If you own 20-30 bonds, you are still not very well diversified. If one or two of them defaults, your entire returns go down the drain.

This is why people buy bond funds, which have hundreds and hundreds of bonds.

If you really want to be an investor in a diversified portfolio of individual bonds, you are probably going to need $5-$10 million, plus another couple of million for your stock portfolio.

Or you can do what I do, which is punt individual bonds around from time to time.

With individual bonds, if you are right you make a little. If you are wrong, you lose everything. Investing in individual bonds is a negative art.

Investing in bond funds is not.

Bond Funds

There are a lot of bond funds to choose from. This is pedantic enough, I am not going to go through them all here.

Let’s assume that we are talking about a corporate bond fund of some sort, high grade or high yield. It has hundreds of bonds.

How do you evaluate bond funds?

Well, you look at the yield. And you look at the credit quality. These are things that will be in the prospectus or fact sheet. If you are like me, you will dig in to see what’s in the portfolio.

Pro tip: the manager of a bond fund counts. Even more than a stock fund. The best managers will put up the best returns year after year.

Also, don’t trust the Morningstar ratings, because the Morningstar folks look at costs, which you shouldn’t care about.

(I mean, if a corporate bond fund has a current yield of 3% and has 1.50% operating expenses, then yes, you care about costs. By all means, look at the operating expenses. But unless they are grossly out of whack, you shouldn’t care all that much).

Bond ETFs

Bond ETFs, of course, are an alternative. Maybe.

Some of the most popular bond ETFs—LQD (investment grade corporate) and HYG (high yield corporate) are not something I would recommend because they are popular.

As you know, most ETFs track an index. This is true of bond ETFs. But the bond indices have a lot of bonds, and it is impractical for a bond ETF market-maker to own every single bond in the index.

So they own a subset of those bonds, and those bonds tend to be quite expensive. You, the retail investor, end up overpaying for bonds, which means you get lower yields.

Compare the yields of bond ETFs to open-end mutual funds—you will see they are much lower.

Also, the ETFs tend to be trading vehicles. There are options listed on these ETFs, and short-term trading activity can really push them around.

Some dumb people have said that these ETFs will “blow up” someday, but that’s not true. Of all the things to worry about with bond ETFS, that is not one of them.

Building a Portfolio

Building a portfolio of bond funds is a bit complicated. Basically, you’re going to want a mix of Treasury, investment grade, high yield, municipal, and international funds, if you want to be diversified.

If you have a view on rates, you can overweight or underweight Treasurys.

If you have a view on credit, you can overweight or underweight corporate bond funds.

Etc.

I will say that people are pretty loaded up on high yield these days, because interest rates are so skinny.

But high yield is pretty strongly correlated with the equity market, so at some point people might find that they do not have the diversification they thought they had.

There is a lot to understand with bonds, which is, I think, a big reason people don’t invest in them as much as they really, really should.

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