Financial guru Suze Orman says to say no to bond funds and yes to individual bonds. Her rationale is that if interest rates climb in future years—as is likely given today’s very low levels—the prices of existing bonds with lower rates will fall.
The impact may be felt more keenly by holders of bond mutual funds and exchange-traded funds than by investors who have bought individual bonds. Owners of individual bonds can wait and collect their full principal upon maturity.
The thrust of the argument is that building a laddered portfolio of individual bonds eliminates the interest-rate risk from potential rising rates. This argument, appealing as it might be, is simply wrong, and here’s why.
Debunking The Myth
Let’s say an investor buys a one-year corporate bond at a $1,000 face value that pays a 3 percent interest rate at the end of the year. She expects to get back $1,030 in a year. The bond is worth $1,000 today because the market pegs the 3 percent rate as a fair rate for this type of bond. The math behind it goes like this: $1,030/1.03 (one plus the interest rate) = $1,000.
In this hypothetical example, immediately after she buys the bond, news comes out of increasing inflation expectations, and suddenly investors want a 4 percent yield on this type of bond. Looking up the value of his bond, she finds it is now worth only $990.38 ($1,030/1.04), declining by $9.62. Still, this investor may take comfort in not having lost a dime, as she is still going to get the $1,030 back, which is exactly what she bargained for.
Unfortunately, she is only going to receive $30 interest when the market now demands $40 interest for this type of bond. This translates to receiving $10 less in one year, based on the current 4 percent return expectation. The investor is immediately out $10.00/1.04, which is exactly equal to be the $9.62 decline in value of her bond. Not merely a coincidence.