Individual bonds or bond fund?
It's an easy choice!
(intro)
(music)
The major factors in deciding whether to use
a bond fund come down to convenience, costs,
and control over maturity.
You don't need much diversification if you
use CDs and US Treasuries, and you can own
these with no purchase fees or annual expenses.
Other individual bonds, on the other hand,
can have spreads between the bid price and
the asking price from one-half all the way
up to five percent, and you will, unfortunately,
have no idea that you are paying these hefty
fees to your broker.
For most of us, a bond fund is a more efficient
way of investing in bonds than buying individual
securities.
Bond mutual funds are just like stock mutual
funds in that you put your money into a pool
with other investors to be invested professionally.
This can be done at a very low cost.
The thing that some find confusing is that
generally bond funds never mature.
So while there's not a specific date when
they'll return what you invested, the fund
has a price and you can sell it at any time.
Remember, we don't expect this price to appreciate,
like we would with the stock of a growing
company.
We care about the total return, which we'll
talk more about later, and sometimes we care
about how sensitive that price is to interest
rate changes.
That sensitivity is best expressed by its
duration.
A short-term bond fund is less sensitive to
interest rate changes than a long-term bond
fund.
Now it's time for some fun.
I'll give you two facts.
You choose the fact that is true.
Here's one: An interest rate increase can
be good for investors.
Here's the other: A bond fund is just as risky
as a stock fund.
This is False.
First of all, a terrible year in the stock
market is when the value of your investments
drops forty to fifty percent.
Whereas a terrible year in the bond market
might be if interest rates suddenly jump a
few percent causing the value of all bonds
to drop.
Hang on though, if you chose a bond or bond
fund that you'll hold for longer than its
duration, then rising interest rates are actually
your friend.
This is True.
If you reinvest dividends at the new higher
interest rate, then you come out ahead if
you hold bonds for longer than their duration.
Let me make an example to illustrate this.
This investor buys a 30-year 5% Treasury bond
at par, and seconds after it is issued, yields
suddenly rise to 10%.
This bond is now worth less than 53 cents
on the dollar.
However, since this bond throws off coupons
which can be reinvested at the new higher
yield, it takes our investor less than 11
years to break even -- so this defines the
bond's duration.
And note that because of the coupons, the
duration is always less than the maturity,
sometimes considerably so.
To reiterate, after 11 years, this investor
is better off for the fall in price because
of the rise in yield.
The duration is the period of time at which
you are indifferent to interest rate changes.
Let's stop and recap this series so far:
Bonds are essential to every investment portfolio
-- even when yields are at record low levels
-- because stocks are so risky.
Owning the right amount of bonds helps make
that stock market risk palatable.
They're the perfect investment when you need
money at a specific time.
And bonds that are uncorrelated with the stock
market are a very attractive diversifier.
Stocks, Bonds, and Money Market Funds are
each very different, and we took a look at
this to introduce this current series about
bonds.
CDs are a special type of bond, and we looked
at how and why, sometimes, CDs are better
than bonds.
Then we talked about bonds and their two major
attributes: the quality (or credit rating)
of the issuer, and the length of the bond.
We saw how a bond price is tied to the interest
rate, and introduced the concept of "duration"
to describe price sensitivity.
It is easy to buy CDs and individual bonds
from your bank or broker and make a bond ladder.
This is interesting for the lowest possible
annual expenses, and when you want them to
mature on a specific date for some reason.
For most of us, a low-cost bond fund is the
way to go and we looked at how duration helps
us decide between short-, intermediate-, and
long-term bond funds.
The next set of videos to finish this topic
will be about the risk and returns of bonds,
and tips about how to stay ahead of inflation.
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