Book of Wise Investors

One of the standard financial instruments that almost everyone heard about is bonds. However, most high grade bonds issued by large and well known corporations are sold to institutional investors like pension funds, sovereign wealth funds, insurance companies and banks, in which they will hold for long term to earn the stability in returns.

Assuming that you intend to invest in some fixed income instruments to diversify away risks, bonds are one consideration. Then how to decide whether to invest through a bond fund or through direct ownership of bonds?

This is like whether to hold individual stocks or to invest through a so-called professionally managed mutual funds/unit trusts.

You can look at the following table here for a quick comparison for the plus and minus of holding bonds through a bond fund or directly,

http://personal.fidelity.com/products/fixedincome/considering.shtml

Basically, the first criterion is how much you have to invest in the first place. Corporate bonds usually need sold in $5000 face value and they are usually sold in blocks of 15 bonds, just like shares are usually sold in lots of 100 shares, 1000 shares etc. As you can see, a high capital is needed just to buy 15 corporate bonds of the same company with triple As ratings and without diversification.

Although in general, a newly issued corporate bond cost $5000, but to achieve adequate diversification, one needs to hold bonds across different sectors and issued by different corporations and coupled with the fact, one does need substantial capital of at least $100 000. Other disadvantages include having to educate yourself completely on all the other aspects of bond investing.

This is clearly not economical for those with less than $10 000 to invest in bonds directly. There is no diversification, unlike a bond fund which holds a basket of many bonds issued by quite a number of corporations. This is in addition to, unlike equities, where $10 000 can already hold many distinct stocks, $10 000 can at most hold two bonds from two different companies but there is limited capital appreciation from bonds but high risk, whereas diversifying the same $10 000 into small cap stocks can return higher capital appreciation with slightly lower risk.

Of course, the most risk free way to invest in corporate bonds is to buy very high investment grade ones (for example, those issued by General Electric) and then hold on to maturity so that you can guarantee to earn the yield to maturity, that is provided the corporations issuing the bond did not default on their bonds and should they defaults, don’t have enough assets to pay back the loans from issuing the bonds.

The key question is, should you have substantial capital and decide to choose between bond funds or direct ownership of bonds, which should you choose?

Bond funds as with mutual funds for equities will got many and high expenses like sales load, management fees, among many others. Before there is any return, one already makes a lost on the many fees being charged.

This is where investing in bond funds (holding corporate bonds) may bring not much greater returns than risk free fixed deposits and treasury bonds.

Bond funds generate returns in two ways, one is coupon payments, and another is capital appreciation in bond prices. If you add up all the fees in percentage terms and subtract from interest payments in percentage also, what did you get?

Let us look at capital appreciation from bond prices, in general, when interest rate rises, bond prices fall and vice versa. As a result, you stand a higher chance of making higher positive returns from bond funds if you enter when the interest rate is already very high and unlikely to rise further.

As for direct ownership of bonds, one has to track and buy individual bonds so as to buy below face value. One must know that there is still volatility in bond prices and the best and effortless way to invest is to buy at below face value and then hold on to maturity and earn the yield to maturity so that can save the trouble of having to look at the computer screen for daily bond prices. (Assuming that you did not invest in junk bonds in the first place)

As with individual stocks, this involves educating yourself thoroughly about bonds. There are many factors that determine bond prices, the main factor of which is interest rate as mentioned above.

The conclusion is that if one has a sum above US$400 000 do not restrict yourself to just bonds and bond funds for stability. There are still boring utilities stocks whose share prices do not drop too much even during a prolong bear market. In addition, there are constant dividends arising from their fairly constant revenue as people still need the services procure by them during a recession or bear market.

If the demographic profile within a certain geographic area shows promising returns in rental income, investing in properties for rental income is also a better choice than bond funds.

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4. Are you aware of what your mutual funds own?