Own Individual Bonds Instead of Bond Funds

For the bond portion of our portfolio, I prefer to own individual bonds and hold them to maturity over owning bond funds. My simple reason is that bond funds will fluctuate with interest rate volatility, while individual bonds will pay face value at maturity. How the Financial Crisis Impacts Your Retirement by Craig Guillot of Bankrate.com reports how retirees learned that their "safer" bond funds recently had negative returns. That's because from September to October, 2008, interest rates for non-Treasury bonds shot up, causing the market value of the bonds to decrease, and therefore reduced the net asset values (NAV) of bond funds.

The individual bonds in our portfolio also declined in value. However, since we were planning hold them to maturity, we expected to get 100% of our principal returned. In the meantime, we will continue to get 4 to 5% annual yields. Thus, it didn't matter the market value was lower in the short term, unless the bond was going to default, which is not very likely for the municpal bonds and CDs (which are treated like bonds in my brokerage accounts).

The downside of individual bonds is that there is less financial flexibility. The minimum investment is $1000 for CDs and $5000 - $10,000 for municipal bonds. The default risk is also higher for a single municipal bond, especially since bond insurers may not be able to cover losses. Finally, there is less liquidity, since selling a CD or bond before maturity often has to be done below the purchase price.

Here's what I do when owning individual bonds and CDs:

1. Own high quality municipal bonds and FDIC insured CDs. For municipal bonds, I try to stay with double A and Triple A that are insured, for what ever that's worth. Virtually all CDs are FDIC insure, make them relatively risk free for default.
   
   With the likely increase of corporate bankruptcies, I am currently staying away from corporate bonds.



2. Diversification. I typically limit the maxium amount of any issue to $10,000. That way if there is a default or bank failure, a maximum of $10,000 is at short term risk.



3. Short maturities. Most of the bonds and CDs mature in 5 years or less. In a moment of weakness, I did buy three callable bonds with attractive yields at 20 year maturities. One has already been called due to declining interest rates. I expect the other two will eventually also be called.



4. Laddering of maturities. I typically distribute the bond investments evenly across a five year time period. It enable me to hedge against both falling and rising interest rates, since 20% of the bond portfolio matures each year. Thus, if interest are falling, 80% of the portfolio is still invested at higher interest rates. If interest rates are rising, I have 20% of the portfolio to reinvest at the higher rates.

While our bond investment approach won't protect against significant short term inflation, it has provided an excellent financial buffer during the bear stock market of 2008. Of course, the benefit will be lost if there is a default. Therfefore, I have recently been shifting away from muncipal bonds and increasing the proportion of CDs, which are FDIC insured.

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This is not financial or investing advice. Please consult a professional advisor.

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