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I’m occasionally asked why we don’t purchase individual bonds in client accounts.  This is typically posed by an incoming client with existing bonds purchased back when rates of 5% or higher were not uncommon.  It can seem like a no-brainer – loan a company money for a few years, receive a fixed interest payment and then cash out your original investment at a pre-determined date.  It’s not as risky as owning an individual stock, right?  Not necessarily.

Today, the risk associated with any individual investment was called to attention when I learned a client’s bond, which was set to mature on Friday, was not repaid.  Suntech, one of the world’s leading manufacturers of solar technology, is experiencing cash flow problems after heavy losses in 2012.  They’re actively working on raising enough funds to pay the money due to its bondholders, but that’s now not likely until May.

Much like with stocks, The Asset Advisory Group (TAAG) believes in investing in bonds through very low cost institutional mutual funds.  This method allows for adequate diversification so that if a company does go bankrupt (and some inevitably will), the exposure will not have a material impact on the portfolio value.  We especially find this to be important in bonds.  Bonds should serve as your “mattress money,” buffering from wild swings in the stock market by protecting the profits you’ve reaped and providing a potential source of cash both for income and potential additional investment.

Not all bond funds are created equal.  In the last few years it has been tempting to take additional risk with your safety net in search of higher yield, as Carl Richards blogged about in February.  When analyzing a client’s 401k last week, I noticed he had moved some of his bond money from the lower yielding fund I recommended to one paying 5.25%.  This seems like a good move, as long as the fund doesn’t experience the -31.90% return it did in 2008 and you discover your mattress money has been hidden in a waterbed which has just sprung a leak! 

In stocks, bonds or any investment, the reward of potentially higher returns comes only when balanced with the costs of taking additional risk. 

At TAAG, we use Dimensional Fund Advisors’ bond funds to invest in short term, high quality holdings.  When interest rates start their expected rise, these funds will hold bonds that are continually maturing and will use those proceeds to purchase bonds with rising yields.   A typical client portfolio has exposure to over 800 bonds and in the unlikely event one of the issuers cannot repay their debt, the impact will be minimal. 

Our philosophy for investing in stock, bonds or any instrument is the same – owning a low cost, globally diversified portfolio is the most prudent way to trade a fair amount of risk while increasing your long term return.