Single-Name Bonds vs. Bond Funds
Investing in Bonds: The Dilemma
With interest rates currently higher than they’ve been for some time, it may be tempting to invest in a high-quality bond for years to come.
To give you an idea, high-quality bonds maturing in 5 years are currently yielding approximately 5% each year till maturity, which has understandably sparked excitement amongst cash holders.
So, how should cash holders proceed? The best way to tackle this question is in the form of an anecdotal story about two investors, let’s call them Alex and Noah, who both invested in 2006.
Bonds and Diversification: An Example
Alex had saved a considerable amount of money throughout his career and in 2006, at the age of 50, decided to invest in a high-quality 5-year bond of Lehman Brothers. He was a savvy investor who had always been careful with his money, which attracted him to fixed returns on deposits and bonds.
However, Alex's brother Noah had a different approach to investing—he believed in diversification and had invested in a bond fund that included a variety of bonds from a variety of issuers. Noah rightfully felt that this approach offered him more protection against potential risks.
Unfortunately, things didn't turn out as either of the brothers had hoped. In September 2008, Lehman Brothers filed for bankruptcy, causing a financial crisis that had far-reaching effects around the world. While Noah’s diversified bond fund took a hit, he was able to recover his losses after waiting for the market to recover, and ended up even making a gain. On the other hand, Alex lost his entire investment permanently due to the concentrated risk he took. As the old saying goes: don’t invest all your eggs in one basket.
A few notes to add here are:
- In 2006, Lehman Brothers was rated A2 by Moody’s and A by S&P (a.k.a. having a very strong capacity to meet their financial commitments; similar and a bit higher than that of Citi, Standard Chartered, and HSBC today as a reference).
- If Alex had instead put his funds in a fixed deposit with Lehman Brothers, he still would have incurred a loss as deposits and bonds are both exposed to the risk of Lehman’s financial stability.
Conclusion: Moral of The Story
Diversification and a robust financial plan are key to successful investing. A well-constructed plan, much like a sturdy ship, can navigate through unexpected rough waters and still reach its intended destination.
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