From the 1980s to the 2020s, bond mutual funds enjoyed a generally favorable environment of rising prices. However, wise mutual fund investors are those who learn how to build a diversified portfolio of fixed-income bonds, which includes selecting individual bonds.
Learn the Basics of Bonds and Bond Mutual Funds
If you have mainly gained your exposure to bonds through bond mutual funds, you will benefit from learning the basics of how bonds work. A bond is a promise to pay – it is a loan. The borrower is an entity such as a corporation, the U.S. government, or a publicly-owned utility. These entities issue bonds to raise capital. The money raised by the entity helps finance new projects or internal operations. The buyers of bonds are the investors. They lend money to the entity by purchasing bonds, in exchange for periodic payments with interest.
Understanding the Difference Between Bonds and Bond Mutual Funds
Bond mutual funds operate differently. With bond mutual funds, the investor does not directly hold the bonds. Bond funds carry greater market risk than bonds because the investor in a bond fund is fully exposed to the possibility of price declines, while the bond investor knows exactly how much money they will make if they can hold the bond until maturity.
Know the Basic Types of Bonds (Corporate, Municipal, Treasury, High-Yield Bonds)
There are several different types of bonds, but the basic types include corporate bonds, municipal bonds, treasury bonds, and high-yield bonds (or “junk” bonds).
U.S. Treasury securities, also known as Treasuries, are debt obligations issued by the U.S. Department of the Treasury. When you buy a treasury, you are funding the operations of the federal government. In other words, you are lending money to the federal government. There are four types of Treasuries:
- Treasury bills (T-Bills), which mature in one year or less
- Treasury notes (T-Notes), which mature in periods of 2 to 10 years
- Treasury bonds (T-Bonds), which mature in periods of 20 to 30 years
- Treasury Inflation-Protected Securities (TIPS), which are bonds protected against inflation
Corporate bonds are debt obligations issued by companies to raise capital for corporate projects and other means of expanding the issuing company. When you buy a corporate bond, you are lending money to the company rather than the government, but they work in much the same way – investors receive a specified amount of interest until the bond matures, at which point the original amount paid to buy the bond is returned to the investor.
Municipal bonds are bonds issued by government municipalities or their agencies. Examples include cities, states, and public utilities. These debt obligations are used to raise funds to finance the construction of schools, parks, highways, and other public-use projects.
High-yield bonds, commonly known as junk bonds, are bonds that have credit quality ratings lower than investment grade (rated below BBB by Standard & Poor’s or below Baa by Moody’s – AAA is the highest). A bond may receive a lower credit rating due to the perceived risks associated with the bond-issuing entity. Thus, because of this relatively higher risk, the issuing entities of these bonds will pay higher interest rates to compensate investors for taking on the risks of buying the bonds (hence the name “high yield”).
Learn How to Research and Buy Bonds
You don’t need to be an expert to conduct bond research. All the knowledge, terminology, and complexities related to the bond markets can be accessed simply through a few strategies and helpful websites. Bond analysts and credit rating agencies do most of the work for you by assessing the risks of the bond and assigning a corresponding credit rating. Therefore, a bond investor only needs to know where to look and how to interpret the information that is already available.
You can
Using mutual fund research sites to find out who the top mutual fund managers are that hold some ideas in their portfolios. Any financial institution you use for brokerage or retirement is likely to provide you access to bond credit ratings and other investment ideas.
Avoid Overlap and Aim for Diversification
Like mutual funds, overlap can occur when purchasing individual bond securities. Try to build your bond portfolio with a diverse mix of maturities (1 year, 5 years, 10 years, 30 years) and types of bonds (Treasury, municipal, corporate, high yield). Within your corporate bonds, try to diversify the industries you are exposed to (financials, healthcare, manufacturing, retail, etc.).
Consider the Core and Satellite Portfolio Structure
Even if you feel that the risks associated with mutual fund prices will dominate for a long time, there’s no reason to completely abandon bond mutual funds. For the sake of diversification, it would be wise for investors to consider holding at least one bond mutual fund as a core for fixed income, and then build additional investments around that core. It’s a type of “core and satellite portfolio structure” commonly seen with full mutual fund portfolios, although mutual funds usually include both stock funds in addition to bond funds.
Source: https://www.thebalancemoney.com/how-to-choose-and-buy-bonds-2466534
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