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As an individual investor I have been investing the percentage of my portfolio dedicated to bonds in either bond ETF's or mutual funds, but I'm concerned this may not produce the price stability and income that it's meant to produce. Here is why: When you invest in individual bonds, if you hold the bond to maturity you are guaranteed to get the principle back and the given interest rate. However if I buy a bond fund my principle is not safe and the price will drop in a rising interest rate environment no matter how long I hold on to the shares since there is no maturity date. Also the interest rate will fluctuate. So I lose the balancing aspect of bonds as diversification to stocks because the price of both will drop with an interest rate increase. So my question is: Is this difference between individual bonds and bond mutual funds significant enough to warrant my attention? and how can an individual investor buy single bonds without paying huge premiums?
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yes, and use a broker like e-Trade, Zions Direct or Fidelity where bid and ask are prominently displayed.

Best wishes, Chris
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Is this difference between individual bonds and bond mutual funds significant enough to warrant my attention?

Yes. As you pointed out the two are not equivalents and thus need to be treated differently. Bond funds have their issues that need to be mitigated. Holding individual bonds has its issues that need to be mitigated. If you understand the risk of either or both then you are half way to managing those risk in a prudent manner.

how can an individual investor buy single bonds without paying huge premiums?

Careful shopping with the right discount brokers and it is not overly brutal. Its not as neat and clean, spreads are far more variable, as stock buying but it is easily workable.

jack
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Hi Guys,

One advantage of the bond ETF or MF is that they will contain a very extensive 'ladder', and if rates are rising, the maturing bonds will be replaced with bonds yielding a higher rate, or existing bonds bought at a good discount, again yielding a higher rate. Whereas, the indiv. bonds are 'stuck' with the low rate and must be held to maturity so as not to incur a loss..

rk (long both indiv. bonds and funds)
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rk,

I can agree with you if we are talking about a managed mutual fund with reasonably savvy leadership. The passively managed funds are at the mercy of the market because little real shopping is done.

jack
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Is this difference between individual bonds and bond mutual funds significant enough to warrant my attention?

gtwolf,

Now that I’ve done my investing work for the morning, I’ve got time to comment on your question, the perennial one of “Bonds vs. Funds?” meaning,

“What might be the advantages/disadvantages of each?”

Like everything else in the investing world, bond funds and individual bonds are merely means to an end, which can be of only three types:
(1) The investor’s intention is to appreciate capital (meaning, end up with more purchasing-power than he/she begins with).
(2) The investor’s intention is to preserve purchasing-power over the intended holding-period of the investment.
(3) The investor’s intention is to conserve his/her purchasing power (meaning, allow purchasing-power to be eroded at a predictable and tolerable rate).

Let’s consider the latter goal. If one’s marginal tax-rate is 35% and if one’s personally-experienced inflation-rate is 5%, then an investment return of 7.69% merely puts the investor even with respect to preserving purchasing-power. Therefore, if the investor is only pulling down 6%, he/she is losing money at a steady and predictable rate, which might be tolerable and intended. It all depends on the investor’s goals. If he/she is beginning with a huge pile of money and merely wants it to last the remaining years of his/her life, then tolerable loss-rates are easy to project, and suitable investment vehicles are easy to find.

But that isn’t the case that most investors face. They have no idea what their costs of living really are, and they have no idea how those cost will increase/decrease over long time frames. Nor do they have a 10-20 year track record of pulling more money out of markets than they brought to it. What they do have is a lot of silly ideas that investing is so easy that anyone can do it well and, paradoxically, that investing is so difficult that it should be left to “experts”.

What effective bond investing does require is two things: an edge and effort. You’ve gotta know why/how you will make your money, and you’ve gotta put in the required time. Ten-minutes-a-week millionaires don’t happen with enough regularity that such methods can be trusted. Instead, typically, those who have parleyed a grub stake into a serious chunk of money are methodical and persistent. They make a steady effort week after week, year after year, good markets and bad, up cycles and down, and the vehicle doesn’t much matter. Bonds or funds, plenty of money can be made with either.

So the question becomes: What kind of volatility are you willing to tolerate, and how much timing/trading do you want to do? There are some truly excellent bond fund managers out there whose funds serve investors well. And these days, buying one’s own bonds is cheap and easy. So the question becomes: “Can I beat the fundies by running what would amount to my own bond fund?” And, more importantly, “Do I want to attempt such a thing?”

Personally, I’d advise a beginning investor to use funds to access areas of the bond market where it’s really tough to compete with the pros and to never use a fund where an individual could easily beat them. Some poking around will suggest to you which is which.

Best wishes, Charlie
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