Bonds vs. Bond Funds: Which is better when interest rates rise?

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The Federal Reserve expects to begin raising its target rate sometime in the near future. Since bond prices fall when interest rates rise, it may be a good time to pay attention to any fixed-income investments you have.

Here are some factors to consider when you review your portfolio:

Maturity dates and duration
Long-term bonds may pay a higher coupon rate than short-term bonds, but when rates rise, long-term bond values typically suffer more. The later a bond’s maturity date the greater the risk that its yield eventually will be surpassed by that of newer bonds.

A bond fund doesn’t have a maturity date, and your shares may be worth more or less than you paid for them when you sell. However, consider its duration, which takes into account maturity and the value of future interest payments. The longer the duration, the more sensitive a security is to interest rate changes. To estimate the impact of a rate change, simply multiply a security’s duration by the percentage change in interest rates.

Diversification
To balance yields with the threat of rising rates, you can diversify across various segments of the bond market. Bonds don’t respond uniformly to interest rate changes. The difference, or spreads, between the yields of various types can mean that some categories are under-or over-valued compared to others. Funds may offer greater diversification within each segment at a lower cost than individual bonds, providing greater protection against the impact of a potential default by a single issuer. However, diversification alone doesn’t ensure a profit or prevent the possibility of loss, including loss of principal.

Flexibility
Holding individual bonds allows you to sell a specific bond on your own timetable or hold it until it matures. That flexibility has two advantages. First, if you hold to maturity, unless a bond’s issuer defaults, you know how much you’ll receive when the principal is repaid. Rising interest rates may cause a bond’s market value to fluctuate in the meantime, but if you hold it to maturity, that fluctuation may not be an issue for you, especially if predictable income is your highest priority.

Second, it can help you manage your tax liability; if a specific bond has lost value, you can sell it and declare the loss on your federal income tax return. You may be able to instruct your broker to sell specific shares of a bond fund to harvest losses for tax purposes, but in general it’s more challenging to manage tax liability as precisely with bond funds.

Laddering individual bonds also can help provide flexibility to adjust to rising rates.

Liquidity
A mutual fund will redeem your shares at the end of every business day. An individual bond traded on the open market may not have the same liquidity, and you could have difficulty finding a buyer who’s willing to pay the asking price. However, individual bonds are priced and traded throughout the day; only closed-end funds and exchange-traded funds have that flexibility, not open-end mutual funds.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016.

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