Individual bonds are an investment, not an Ark

December 4, 2013

(James Saft is a Reuters columnist. The opinions expressed are his own.)

By James Saft

(Reuters) – Some day, perhaps soon, interest rates are going to start to go up decisively.

And on that day, when it comes, some investment advisors are going to stroke their chins and spout nonsense to the effect that you are better off in individual bonds rather than bond funds.

This fallacy, maybe one of the oldest and hardest investment misconceptions to stamp out, hinges on the idea that owners of bonds are not forced to take losses because they can hold their securities to maturity.

Personal finance writer Suze Orman, for example, has stated the case ( here ), equating that right to get your principal investment back with carrying a lower risk.

While it is certainly true, barring default, that you will get your initial investment back from a bond, while a bond fund will price every day, this is not, per se, an advantage.

“Bond funds are just portfolios of bonds marked to market every day. How can they be worse than the sum of what they own?” Cliff Asness co-founder of AQR Capital Management writes in the Financial Analysts Journal ( here ).

“The option to hold a bond to maturity and ‘get your money back’ (let’s assume no default risk, you know, like we used to assume for US government bonds) is, apparently, greatly valued by many but is in reality valueless.”

Of course, the fact that bond funds are marked to market prices every day makes your loss (or gain) easy to see, but bonds too are traded every day, at least most of them. And even if they don’t trade, or if you don’t realize it, all bonds go up and down in value as rates fluctuate.

The truth, of course, is that rising interest rates impair the value of fixed-rate bonds regardless of whether you choose to accept it or crystallize it with a trade. And if you choose to hold your bond to maturity as rates rise you will find that the purchasing power of your returned principle will have been impaired compared to people who own bonds issued at the new higher prevailing rate. Your performance, obviously, will have lagged.

That is simply a risk of holding fixed-interest securities.

PROTECTION FROM YOURSELF

That’s not to say that there are no conceivable advantages of owning individual bonds against owning a portfolio of bonds in a fund.

Some investors, lulled by their ignorance that their individual bonds are losing value as rates rise, may be less likely to sell in a panic when rates rise. Given that these people are highly unlikely to be good at timing the markets and forecasting interest rates this may be a boon, at least to them.

And of course all of this, with its naive emphasis on day to day pricing of securities, ignores the true reason you ought to own bonds in the first place.

As Toby Nangle, of Threadneedle Investments, pointed out earlier this year, no-one buys bonds because they actually think they are going to outperform other assets over the longer-term ( here ) The data is clear, over the longer term bonds underperform equities.

Instead you own bonds because, when combined with equities in a portfolio, they are a complementary asset. Both long-dated US Treasuries and equities are about equal in volatility. But, if you own government bonds and equities together your portfolio volatility will be greatly reduced.

And, as volatility is risky (after all, you may one day want access to your money) that complementary nature is extremely important.

That lower volatility allows you to take on more risk, usually in the form of equities, than you otherwise would be able to.

It remains to be seen which asset class will do worse when rates rise. Much depends, obviously, on why they are rising in the first place.

What is likely to be true is that you’ll do better, with less volatility, over longer periods if you mix bonds into your portfolio.

That, rather than return of principal, is the true safety of bonds.

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on SAFT)

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