By: Kirby Brown, Deseret News
Investors cite a wide range of overall strategies motivating the allocation to bonds in their investment portfolios. A very common allocation observed in investment portfolios with longer-term return objectives and also desiring a moderate degree of market volatility exposure contains approximately 40 percent bonds and the balance in some variety of equity strategies.
Bonds can be purchased with a wide range of risk profiles. A very common approach for many retail investors is to purchase exposure to the bond market in the form of an Exchange Traded Fund, which seeks to replicate the performance of a broad section of the bond market, or in the form of a bond mutual fund.
Like equity mutual funds, there are thousands of different bond mutual funds. A very broad spectrum of risk profiles can be targeted in the different types of bond funds and bond ETFs available in the marketplace.
Bond mutual fund portfolio managers generally compare performance of these portfolios against a publicly available bond market index. These indexes are often comprised of the full range of bonds that exist in the public markets that have the specific credit ratings, maturity, sector, coupon type and other factors in common with the targeted portion of the overall bond market.
Whenever a new bond is issued in the market that falls into the basket identified by the index, the bond will be included in the performance of the index as of the next index rebalancing timeframe. This mechanism of including new issuance generally results in a relatively constant maturity and credit risk profile for the index. The mechanism also results in indexes that never really mature.
Many bond indexes generally don't demonstrate an aging characteristic over time. An investor in portfolios or ETFs that measure performance against these indexes will generally experience the total returns of a constant maturity portfolio.
Market values of the bond portfolios will increase and decrease as interest rates fluctuate and credit spreads widen and contract. Yields will generally track the aggregate market environment for the sectors represented by the specified bond index.
While owning specific bonds instead of a bond mutual fund or bond ETF will bring other unique risks and investment necessities, investors are significantly removed from the withdrawal and deposit volatility introduced as other investors move cash into and out of the bond mutual funds.
Investing in individual bonds requires credit analysis and research about the structure and unique risks of each bond purchased. The benefits may outweigh the additional effort required. Assuming the individual bonds don't default, the face value of the bonds will be returned at maturity or as mandated by each bond's structure.
Fluctuations in market values caused by changing interest rates or other external factors become less concerning when the bonds are held to maturity. For many investors, bond funds or ETFs are the preferred methods to get exposure to this asset class. Yet for those willing and able to do the homework, direct investment in individual bonds may provide the desired insulation from market value fluctuations and the potential swings in fund values caused by liquidity needs imposed on funds by other investors.
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