Over the past two months we've discussed in detail the implications of this summer's spike in interest rates. It's not that the losses in bonds have been so dramatic — compared with other bond bumps over the past 50 years, this summer's doesn't even crack the list of the 10 worst. The problem is most market observers expect that this has just been the tip of the iceberg with much more to come. After 30 years of falling interest rates, culminating in five years of extraordinary Fed policy pushing Treasury yields to all-time lows, it seems likely that rates are going to be on the rise for some time.

Many investors are less familiar with bonds than they are stocks. This creates some confusion, given that stocks trade up and down based on any number of factors. Earnings are the primary driver of stocks' long-term direction, but there's another factor at work — stock investors ride a cycle of optimism and pessimism. This means they're willing to pay more (relative to a company's earnings) to own stock shares at some times than others. This is usually based on their outlook on the economy and a particular company's prospects, but is also affected by the relative attractiveness (or lack thereof) of other investment options available to them at the time.

There's a tendency to believe that a similar subjectivity is true of the bond market as well, but that's not the case. Bond values follow a much more straight-forward math equation than stocks. It's a fundamental principle of bond investing: When interest rates go up, bond prices go down. Here's why. Let's say you buy $10,000 worth of newly issued 10-year Treasury bonds paying an interest rate of 2.5%. If over the next year, the 10-year Treasury rate rises to 3%, an investor will be able to buy new bonds nearly identical to yours, but carrying the higher rate. Obviously your old 2.5% bonds are less attractive than the new 3% bonds available at the same price. So if you want to sell them, you'll need to lower your price below $10,000 to make them competitive in the marketplace.

Knowing there's no way around this dynamic, bond investors get understandably nervous when interest rates are expected to rise. After all, nobody wants to buy an investment right before it drops in value. That's the uncomfortable situation bond investors find themselves in today.

What options exist for a fixed-income investor facing higher future interest rates? Moving money out of bonds and into "cash" (e.g., bank savings, CDs) is an option, but not an attractive one given that interest rates are so low. Shifting money into stocks is unappealing, as stocks carry greater risk, particularly as the stock indexes sit near all-time highs after years of big gains.

SMI has recommended shifting to short-term bond funds and staying away from long-term bond funds. This positioning will help if rates rise, since the shorter the term of the bond, the less its price will decline. But as we saw in May and June, this will only minimize the damage, not stop it completely.

Owning individual bonds

Thankfully, there is a way to own bonds and be totally unaffected by rising interest rates. The solution is to own individual bonds rather than bond funds, and to hold those bonds until they mature. In our earlier example, if the face value of your bonds was $10,000, you might have had to lower their selling price to say, $9,500, to find a buyer after one year. But if you instead held those bonds another nine years until maturity, you would eventually receive your full $10,000 investment back. Any interest-rate fluctuations over the 10 years the bonds were owned would have been irrelevant. Given that, why doesn't everyone simply buy individual bonds instead of bond funds? There are three main reasons.

  • Lack of diversification
    Mutual funds are wonderful tools for spreading the risk of default across many different companies. That's important in bond investing, where even the highest-rated corporate bonds default at rates of roughly 0.11%. That may be only 1 in 1,000, but what if you happen to pick that one and lose 60-90% of your principal in default? Many individual investors lack the capital to adequately diversify using individual bonds. Bond funds allow investors to minimize the risk of default by owning tiny pieces of hundreds of bonds. Further, that diversification allows a bond fund to include some slightly riskier bonds in the portfolio, which boosts overall returns due to the higher yields they pay. (Schwab recommends investors have a minimum of $50,000 to properly diversify a portfolio of corporate bonds. Fidelity's recommendation of $200,000 is even higher. Both firms recommend bond funds for portfolios smaller than these amounts.)
     
  • Cost
    The diversification problem is heightened by the second reason most individuals don't invest in individual bonds: it's expensive. Traditionally, the only way to get a reasonable deal buying bonds has been to have a planner/broker do it for you. Otherwise, the costs were prohibitive. These costs included not only the 1-3% commissions that are still common, but the "markup" dealers have typically charged retail investors.
     
  • Complexity
    If your mind is starting to swirl a bit at this point, it will be easy to understand the third reason most individuals don't buy individual bonds: it's hard. On top of the difficulty of getting a fair price, selecting which bonds to buy is a significant challenge for most people. Some investors may feel reasonably comfortable evaluating individual stocks, but very few feel confident comparing the risk/reward profile of a 5-year callable IBM bond vs. a 10-year Goldman Sachs note.

As you can see, assembling a portfolio of individual bonds can be a challenging task. For most readers, we suggest sticking with SMI's regular bond-fund allocations and recommendations. But those with a high percentage of their portfolio in fixed-income investments may want to consider going the individual-bond route.

The advantages of a bond "ladder"

A common way to structure a bond portfolio so as to (1) minimize interest-rate risk while also (2) providing regular access to your capital is to create a bond ladder. The idea is to initially buy bonds that mature at different times, often at six-month or one-year intervals. As each bond matures, you have the option of keeping the proceeds for personal spending, or you can roll part or all of your money into another bond.

For example, setting up a five-year ladder with a portfolio of $100,000 might involve buying $20,000 worth of bonds maturing at the end of each of the next five years. At the end of the first year, the money received from the maturing one-year bonds could be used to buy new five-year bonds, thus keeping the ladder intact and rolling it forward. This method gives you periodic access to your money through the regularly maturing bonds. It also allows you to eventually have all the rungs of your ladder earning interest at the higher-yielding longer-term rates, while still providing regular opportunities to reinvest at higher interest rates should rates rise.

Your ladder can include bonds with maturities longer than five years, but the conventional wisdom is to keep the ladder short when rates seem likely to rise (as they do now) and long when rates are likely to fall (so as to lock in the higher rates for as long as possible).

How your broker can help

The bigger discount brokerages are making it easier for individual buyers to overcome the traditional hurdles to buying individual bonds. They've cut prices to help individuals get a fair shake buying and selling bonds on their own. And in a few cases, they've also developed helpful tools for evaluating specific bonds and putting together a bond ladder for your portfolio.

Fidelity and TD Ameritrade have tools that enable account holders to quickly create a bond ladder based on their specific desires. These tools allow an investor to select which type of bonds to include (government, corporate, etc.), how safe/risky those bonds will be, the timeframe for the ladder, and how many "rungs" (varying maturity dates) to include. This makes it fairly easy for account holders to set up, for example, a five-year bond ladder consisting of 10 different investment-grade, corporate bonds that mature every six months.

While working with bond ladder tools like these can be helpful (and even fun if you're a researcher type!), some brokers now offer customers direct access to their in-house "fixed-income" team of experienced bond buyers. This can be a huge help if, like most people, you're not experienced buying individual bonds. Look for that type of contact information in the bond-research section of your broker's website and take advantage of it.

Sorting through your options

Even if you're having someone assist you in setting up a bond ladder, you'll still need to make a number of important decisions before you get started. The first is which type of bonds to buy. Most readers are likely to prefer corporate bonds because they pay higher yields than government bonds. The next decision is what credit quality to select. As credit quality decreases, the risk of default increases — but so does the yield paid. Nearby you can see the various ratings used by Moody's and Standard & Poor's to rank the credit risk of a bond. Bonds receiving any of the ratings shown are considered "investment grade," however staying around the A1/A+ range (or higher) is a good idea, especially if you won't be owning a large number of different bonds.

Diversification is another point that deserves particular attention. It's important to diversify among different companies, which you can do by adding additional rungs to your ladder or buying multiple different bonds at each rung. For example, instead of buying five $20,000 positions each maturing one year apart, you might buy ten $10,000 positions maturing six months apart. That will add diversification as well as provide more frequent access to your cash. There's a lot of flexibility in how you set up a bond portfolio.

In addition to diversifying among companies, it's important to also diversify among industries. This is a key point, because many of the higher-yielding bonds available right now are those of financial companies — banks, brokers, insurance companies and so forth. Five years have passed since the worst of the financial crisis, but the entire financial sector still poses significant stability questions, given that many of the root causes of that crisis were never adequately addressed.

Factors that could cause trouble for any one of these companies are likely to disrupt other companies throughout the financial sector as well. Merely diversifying among companies isn't enough. It's worth settling for a slightly lower yield to spread your money among bonds from companies in various industries, rather than accept a bond ladder loaded with financial company bonds.

Here are a few other pointers to help your search process, whether you're doing it yourself or with assistance. "Callable bonds" can be "called" away, or redeemed, by the issuer earlier than their maturity date. These should be avoided. (If using an online tool, answer "yes" for "Call Protection" and "Sinking Fund Protection.") Callable bonds aren't inherently bad, but they are more complex to evaluate and defeat the purpose of the ladder, which is to have bonds maturing on a regular schedule. If your broker displays Price and Risk filter testing (as Fidelity does), look for bonds labeled as "Inline Result." This means the bond has passed a third-party price and risk test.

Finally, ignore the "coupon rate" of each bond and focus instead on the "ask yield" or "yield to maturity" — this is what you'll actually earn if you hold the bond to maturity based on its current price.

Conclusion

Owning a portfolio of individual bonds is an attractive way to manage investment cash flow because it offers a high degree of certainty about what your interest income will be. It can also eliminate any anxiety caused by rising interest rates. If you have a sizeable bond portfolio and aren't nervous about venturing into individual-bond territory, it's getting easier and safer to do so. But it's definitely not for everyone. You shouldn't feel as though you need to pursue this course if you're uncomfortable doing so. Sticking with SMI's recommended bond allocations and funds should help minimize any damage inflicted by rising interest rates.