How should I be investing in bonds as part of a diversified portfolio?

Question

I often hear that I should diversify my investment portfolio with X% stocks and Y% bonds, ostensibly to mitigate the risk.

My question is what exactly this guidance means in terms of HOW to invest in bonds. For diversification purposes it seems like I'd want to do this via a bond fund rather than buying individual bonds. However, it is my understanding that bond-funds don't generally hold those bonds to maturity, but rather trade them like equities. That seems too similar to how my mutual funds operate and doesn't seem like it would be an effective hedge.

Shorter version of my question: If I am trying to follow guidance to, say, put 80% in stocks and 20% in bonds. Does this advice typically mean I should be investing in:

• Individual Bonds
• Bond Funds
• Defined Maturity Bond Funds
• Something else?

Update: I think people are misunderstanding the intent of my question. There are two main approaches to bond investing:
a) Buy and hold to maturity; and
b) Buy and sell prior to maturity (I believe this is how bond funds work).

What I am asking is which of these two approaches is intended by the advice "Diversify your investments across stocks and bonds with some allocation between them."

Answer 1

For most people, you don't want individual bonds. Unless you are investing very significant amounts of money, you are best off with bond funds (or ETFs).

Here in Canada, I chose TDB909, a mutual fund which seeks to roughly track the DEX Universe Bond index. See the Canadian Couch Potato's recommended funds.

Now, you live in the U.S. so would most likely want to look at a similar bond fund tracking U.S. bonds. You won't care much about Canadian bonds. In fact, you probably don't want to consider foreign bonds at all, due to currency risk. Most recommendations say you want to stick to your home country for your bond investments.

Some people suggest investing in junk bonds, as these are likely to pay a higher rate of return, though with an increased risk of default. You could also do fancy stuff with bond maturities, too. But in general, if you are just looking at an 80/20 split, if you are just looking for fairly simple investments, you really shouldn't. Go for a bond fund that just mirrors a big, low-risk bond index in your home country. I mean, that's the implication when someone recommends a 60/40 split or an 80/20 split.

Should you go with a bond mutual fund or with a bond ETF? That's a separate question, and the answer will likely be the same as for stock mutual funds vs stock ETFs, so I'll mostly ignore the question and just say stick with mutual funds unless you are investing at least $50,000 in bonds.

Answer 2

Buy a fund of bonds, there are plenty and are registered on your stockbroker account as 'funds' rather than shares. Otherwise, to the individual investor, they can be considered as the same thing.

Funds (of bonds, rather than funds that contain property or shares or other investments) are often high yield, low volatility. You buy the fund, and let the manager work it for you. He buys bonds in accordance to the specification of the fund (ie some funds will say 'European only', or 'global high yield' etc) and he will buy and sell the bonds regularly. You never hold to maturity as this is handled for you - in many cases, the manager will be buying and selling bonds all the time in order to give you a stable fund that returns you a dividend.

Private investors can buy bonds directly, but its not common. Should you do it? Up to you.

Bonds return, the company issuing a corporate bond will do so at a fixed price with a fixed yield. At the end of the term, they return the principal. So a 20-year bond with a 5% yield will return someone who invests £10k, £500 a year and at the end of the 20 years will return the £10k. The corporate doesn't care who holds the bond, so you can happily sell it to someone else, probably for £10km give or take.

People say to invest in bonds because they do not move much in value. In financially difficult times, this means bonds are more attractive to investors as they are a safe place to hold money while stocks drop, but in good times the opposite applies, no-one wants a fund returning 5% when they think they can get 20% growth from a stock.