BONDS

Few investments have been criticized harder by experts lately than bond funds, but Janet Brown of NoLoad FundX explains here why they should play an important part in your portfolio.

Returns on bonds have been strong and steady over the past couple of years. And from January through November 2012, $346 billion flowed into bond funds and ETFs, while just $11 billion went into stock funds, according to The Wall Street Journal.

Bonds have done well due to high demand, low interest rates, and low levels of defaults. With interest rates at historically low levels and bonds as an asset class priced high, some investors wonder if there is still a place for bonds in their portfolios.

Our answer is yes. Not only do bonds offer income, they also buffer the volatility of equities, which helps investors ride through volatile markets. Given the potential headwinds facing bonds, however, we believe investors may be better off in bond funds than in individual bonds. Here’s why:

1. Diversification: Creating a truly diversified mix of individual bonds would require a portfolio upward of $1 million. But you can buy a diversified portfolio of bond funds for a few thousand, and your holdings are spread out over many individual issues, this reducing credit (default) risk.

Most individual bond investors hold fewer than ten bonds, which may not be very risky when defaults are few and far between. But if the economy falters and more companies default on their debt, there could be greater danger in a homemade portfolio of individual bonds.

2. Expert Research: Most investors don’t check on companies’ financial health before buying their bonds. Instead, they simply buy a bond rated Aaa by Moody or AAA by Standard and Poor’s. But these ratings may not always be reliable, as the debt crisis of 2008 made painfully apparent.

Mutual fund companies really earn their fees by doing the research on companies before they buy their bonds. This is particularly valuable when dealing with lower-quality bonds issued by smaller companies, which often don’t pay to have the ratings agencies evaluate their debt.

 3. Tracking Performance: Assessing the returns of a group of individual bonds can be difficult, because the income is not reinvested and some bond issues may not be readily priced. You’re more likely to pay attention to total return on your bond fund and ETF holdings, and more likely to notice when part of your portfolio isn’t working.

4. Access to Different Areas of the Bond Market: Investors who hold individual bonds don’t usually have access to foreign or emerging market bonds, but bond funds make it easy for investors to invest in niche areas like high-yield corporate bonds, and global bonds, particularly those of emerging-market governments. These areas are likely to become increasingly important sources of returns for fixed-income investors.

5. Liquidity: Perhaps the most important feature of bond funds versus individual issues is liquidity—the ability to exit a particular asset quickly and efficiently. If volatility increases and all areas of the bond market start to decline, active fixed income investors can go to cash.

It’s much easier to sell shares of a bond fund than to unwind a portfolio of individual bonds. After all, a mutual fund is always required to buy back your shares—but no one is required to buy back your individual bond.

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