I’ve always heard there’s safety in numbers when choosing investments, that you should always buy both bonds and stocks in mutual funds.
But I’ve peppered my portfolio with single-stock purchases and it’s worked out. I plan on doing the same with bonds because, if chosen well, they aren’t riskier than buying bonds in bond mutual funds.
The reason why bonds in mutual funds are considered safer is because the biggest risk to losing your money is if a company you bought a bond from declares bankruptcy. In a bond fund, you don’t have to worry as much because you’re invested in a variety of companies with the same maturity date.
However, if you only invest in investment grade bonds, bankruptcy is not as big of a concern, says Rob Seltzer, certified public accountant and personal financial specialist. Investment grade bonds have credit ratings of B and above. Any bond with a credit rating with BB or below isn’t worth the average investor’s time and money. The only reason to buy a bond that isn’t investment grade is if you thoroughly researched the particular company you’re investing in.
But credit rating isn’t the only term you should know if investing in individual bonds. Seltzer also recommends you pay attention to the following:
1. Pay Attention To Duration For Low-Interest Rate Bonds
Right now, if you bought individual bonds, you’d earn a very low interest rate. You have choices of investing in lengths, called duration, of investing in short-term bonds for two years or so on up to long-term bonds with durations of 10 years or more. The important question to ask yourself when buying bonds in a low-interest rate market: Are you prepared to earn a low percentage rate on the money you invested for the duration you selected?
Investing in primarily long-term bonds bought during a time period of low interest rates can impact the ability to retire. It’s possible interest payments won’t even cover the cost of inflation.
2. Bonds Bought New Are Bought At Face Value.
Whether the interest rate you’ll earn is 8% or 5%, the price for a freshly issued bond is generally the bond's face value. For instance, a bond with a face value of $1,000 would still cost $1,000 at issue, no matter when it was issued. The only difference between the two is the interest you earn as an investor.
3. High-Interest Bonds Can Be Sold At A Profit.
A bond bought during a period of high interest rates can be sold for a profit when interest rates are low. Why? Because investors would love to lock in a high rate of return for the remaining duration of the bond.
For instance, if a 15-year bond was bought with a 5% interest and had 13 years left, it would be worth paying more than the initial investment.
4. Your Bond Could Get Called.
Companies may call a bond, pay you the face value of your bond and avoid paying you future interest. The reason why they would do this is if interest rates drop, they’d rather borrow new loans in the form of bonds at a lower interest rate. In this market, this isn’t likely, Seltzer says. However, if interest rates go up, this is a bigger risk. For the company, it’s the individual equivalent of refinancing your mortgage when interest rates drop. You’re not going to ask for a new mortgage if interest rates are higher in the market than what you paid.
5. Tax-Free Bonds Are More Important If You're In A Higher Tax Bracket.
In this case, you’re probably better off with municipal bonds that are tax free. If you’re retired and on a fixed income, you’re in a lower income bracket and should consider high-grade corporate bonds.
The Investing Answer: In this environment with low rates, consider bond laddering. Your advisor can help you develop a strategy of combining investments in bonds of different durations, so you’re not stuck with low interest rates for a long period of time. The short bonds you’re invested in now can be cashed in at maturity and you can buy new bonds when interest rates go up.
