Bonds or fixed income really have two purposes for the US individual investor: income and stability. Some will disagree with me. They would say that you might want to own bonds for appreciation. However, In order to achieve appreciation, you must have institutional investor scale.
In my view this is requires probably $100 million in assets. It requires owning dozens of different issues. It requires at least several credit analysts. Pension plans, banks, and perhaps hedge funds lend themselves to buying—trading—bonds. These types of investors buy bonds at a premium only to trade out of them before they get close to maturing. They perhaps anticipate a credit upgrade and buy before it happens only to then sell them after the upgrade. They might even buy what is known as “distressed debt” and then sell once the bond returns to something approaching its original issue or “Par price.” They buy foreign bonds, thereby making currency and political bets.
The risks of bond mutual funds outweigh the benefits
Dozens of mutual funds invest in fixed income. This is the easy solution for many financial advisors and do-it-yourself investors. However, to my way of thinking, the risks outweigh the benefits.
Today’s incestuous relationship between banks providing financial advice and the asset management business rivals what President Eisenhower referred to in the 1950s as the military-industrial complex. Asset management companies are the servants of wealth management firms. They pay for financial advisor and even client meals. They sponsor events. In many cases they are divisions of the wealth management firm! These events could be a meal with a speaker. They could be multi-day half recreational events that cost the asset manager hundreds of thousands of dollars to get in the door. Yes, they are in essence buying shelf space for their products to be sold to their financial advisors’ clients.
Taking on principal risk by using bond mutual funds.
A dominant part of a many mutual fund complex’s product suites are their fixed income funds. These products fit the vast array of “asset classes” that are used to complete what is currently used as the Markowitz asset allocation puzzle pieces. My issue with this approach is that if you use a mutual fund for your fixed income, you are immediately taking on principal risk. If instead you buy the bonds outright, you are clearly taking on credit risk, but absent an investment grade company having a credit event, that is the only risk to which you expose yourself. You can always patiently wait until the bond matures to collect the principal you have invested.