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The Money Prof
Wednesday, July 1 2015
Should I Buy Bonds Directly or Bond Funds for Income?Retirees and individuals seeking current income have found the markets very unfriendly over the past decade. Historically low interest rates have reduced family incomes dramatically. Of course, borrowers have enjoyed low rates at the expense of investors. Contributing to these low rates has been a sluggish economy, but probably even a greater contributor has been the Federal Reserve's monetary policies. It seems to me (as an non-economist) that with an $18 trillion dollar national debt, interest rates have been kept purposely low to ease the interest expense on this unprecedented Government debt. All at the dear expense of retirees and investors seeking income.
The purchase of bonds has always been a way to create income. Bonds pay interest twice a year (semi-annually). Bonds with longer term maturities carry higher interest returns and yield's to maturity than shorter maturities (under normal yield conditions). This is because the risk is greater on longer term bonds to investors. Longer term bond prices fluctuate more than shorter term bonds that mature and are repaid to investors. Another way of stating this, is shorter term bonds are considered more liquid than longer term bonds. Bond income is a function of not only the general level of interest rates in the economy, but bond maturities, ratings, and the type of bond. Some investors "ladder" their bonds. They purchase bonds with different maturity dates. As the shorter term bonds mature, they are replaced with longer term bonds. By doing this, investors capture the change in interest rates with the purchase of replacement bonds. A big advantage of buying bonds directly is "control." You can plan cash flow return based on the maturity dates. By doing this, investors are guaranteed the face value back on the bonds. The risk in buying bonds directly is related to the bond's credit rating. Investing too much money in lower rated longer term bonds can be risky. Investment grade bonds are rated AAA, AA, A, BBB). Bonds rated BB and below are considered risky and referred to as "junk" bonds.
Investors should make sure they are well diversified when purchasing corporate and municipal bonds directly. US Government bonds carry no default risk. Another approach is to buy bonds that are pooled together in the Fund universe (that includes mutual funds, closed end funds, unit investment trusts and exchange traded funds.). Buy purchasing bonds this way, the benefit of diversification is realized. Investors do have less control over bond funds because the Fund does not generally mature as new bonds are replacing maturing bonds in the portfolio, and are therefore, subject to interest rate risk and possibly price decline. However, since bond funds can carry hundreds of bonds in the portfolio, different bond ratings can increase income while carrying less portfolio risk if done the right way...
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