Got a question about Series I bonds or other fixed-income investing, how it fits into your overall financial plan and what strategies can help you make the most out of your money? You can write me at beth.pinsker@marketwatch.com.
Dear Fix My Portfolio,
Bond funds are the devil in disguise. Why do I say this? Because individual investors are drawn to bond mutual funds for three main reasons: instant diversification, professional management and in-and-out liquidity. But they never stop to ask what they are actually buying.
You recently wrote an article that compared bonds to bond funds, and most of the advice was that individual investors were better off in bond funds. I disagree.
Investing in a bond fund is a bet on interest rates, plain and simple. If rates go down over your holding period, you win. If they go up, you lose. Ninety-nine out of 100 bond-fund investors never think about that. And I guarantee you that was certainly not their intention when they bought a “safe” mutual fund.
The fund investor often panics. We can see their emotional response to volatility in fund outflows. All of us have an innate tendency to interpret large temporary declines in the market as the beginning of the end. And when we panic, we flee. We sell at the wrong time and incur that permanent loss of capital. There is rarely a reason to sell a quality bond at a loss.
If the recent collapse in bond funds doesn’t scare people off them forever, I don’t know what will.
JW
Dear JW,
You bring up a good point, so thanks for writing. Bond funds are the “easy” solution to investing in fixed income for most individual investors, but they still require some advanced knowledge of financial markets, and some careful attention to detail when buying. That said, it’s not impossible for people to get up to speed enough to make it work without needing to become chartered financial analysts.
A fund’s stated objective is the most important thing to look for when you’re selecting a bond fund. “There are lot of different types of bond funds. This is why you want a true-to-label fund manager,” says Chris Tidmore, senior manager at the Vanguard Investment Advisory Research Center, who actually is a chartered financial analyst. “You want a fund where they do what they say they’re doing.”
The alternative is a “go anywhere” fund, where you assume it is being diversified, but the fund managers can actually do whatever they want behind the curtain.
Figuring out what kind of bond fund to buy is a little trickier than just buying a broad market equities fund, like one that tracks the S&P 500 SPX. That’s because, as you point out, bonds do not behave the same way as stocks, and bond funds don’t perform the same way as stock index funds. Not everyone agrees that investing in a bond fund is just a bet on interest rates because of the yield involved.
“On your trading platform, you should look for total return, as opposed to price return. The total return is the important part. It will reflect more than just the price going up or down, but also will reflect all the interest payments,” says Kristy Akullian, senior iShares investment strategist at BlackRock. “Total return may be positive, even when price return is negative.”
Because of current economic conditions, Akullian says there’s an opportunity right now to sell bond-fund shares you may have bought several years ago, which are currently priced below what you paid for them, and use those losses to offset gains for tax-loss harvesting purposes. Then you can rebalance your portfolio to maintain the intended degree of fixed income in your portfolio by investing in new bond funds. You would then be on the right side of the price curve, buying low and expecting interest rates to drop so that prices rise.
“You want to own a core bond-fund profile, and if we’re talking in duration, that would be a three- to seven-year term,” says Akullian.
Buy the right bond funds
When you’re looking for new bond investments, look for funds that specifically invest in those durations. You’ll have to do a little more than just look at the ticker symbols — you’ll also need to click through to the prospectus and read the terms. “Bonds are constantly rolling in and out of that kind of fund,” says Tidmore. “The average duration is five years, but they’ll have a range from three to seven years. And so when bonds get to the end of the three-year duration, the fund managers will take the proceeds and buy new seven-year bonds.”
All along, you as the investor will get yield. In a bond exchange-traded fund, this will likely be in the form of a monthly dividend, which can either be reinvested in the same fund, redeployed elsewhere in your account manually or taken as cash. But you should note that you will owe taxes on that amount as ordinary income. The only way to offset that income is with an overall capital loss for the year, of which you can claim up to $ 3,000 against ordinary income. If you own shares of a bond mutual fund, you’ll get the regular income, plus perhaps capital-gains distributions.
Akullian says this is where she sees most of the ire aimed at bond funds. “A lot of people have had a bad experience in bond funds, and a lot of that comes from bond mutual funds — getting capital gains and having to pay taxes,” she says.
JW, you say individual investors are notoriously bad at knowing the optimal times to buy and sell, but there’s a way to do that with bond funds. Bond ETFs with specific durations do not roll over constantly, so the way they act is more akin to bonds — or, rather, target-date funds. With those, you can more easily build bond ladders with staggered maturities, and also know the key inflection points where you plan to sell and reinvest on your own.
“One of the things that confuses people about bond funds is that they are perpetual in nature. They don’t ever mature. That feels different,” says Akullian.
But funds like iShares’ iBonds — not to be confused with Series I Savings Bonds — have a range of funds that are designed to work like individual bonds. These are funds like the iShares iBonds December 2024 Term Treasury ETF IBTE, which had a total return of 3.4% year to date, even as the price was down 0.05% in the same period.
“You can buy a fund of Treasury bonds that all expire in 2033, or you can do three- or five-year durations,” says Akullian. “With bond ETFs, at least on the capital-gains side, you only have to pay when you make a decision to buy and sell.”
More Fix My Portfolio
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Retirement bond anxiety: Even with 6% yields, you can’t set and forget it
I bought Series I bonds, then forgot about them. Are they still worth anything, or should I sell them?