What is the best way to buy bonds as a retail investor?

The easiest way to add bonds to your portfolio is to buy a cheap, well-diversified exchange-traded fund designed to cover off the corporate and government bonds markets in a single purchase.

That’s the easiest route – but not necessarily the best. The best bond solution comes down to your investing psychology: Are you going to freak out if the bond market tanks and the supposedly safe part of your portfolio falls in value?

The utility of bonds and bond funds was the subject of a recent question from a reader. “I am a DIY investor and I am interested in buying Canadian bonds to hold to maturity as the fixed income portion of my portfolio,” he wrote. “What is the best way to buy bonds as a retail investor? The bond market doesn’t seem that transparent to me in terms of pricing, fees, spreads etc.”

The bond market can be a bit of a challenge for DIY investors using an online broker to buy individual bonds. The good news is that you can browse your broker’s inventory to pinpoint term, yield and risk that meet your needs – maybe a five-year corporate bond with an investment-grade rating and a yield of 3 per cent or more. The bad news is that brokers use bonds as a profit centre and don’t price them competitively. The higher the price you pay for a bond, the lower the yield (bond prices and yield move inversely).

Bond ETFs work around this because they’re able to acquire bonds at better prices than retail investors. Even after management fees, the yields on bond ETFs can be quite competitive. The problem with both bonds and bond ETFs is that they can fall in price when interest rates rise (and rise in price when rates fall). Individual bonds at least will mature and pay you back your principal. Bond ETFs typically keep on rolling through the years, which means repeating cycles of rising in price as rates fall and then giving back those gains when rates rise.

Both bonds and bond ETFs give you the full benefit of bonds, which is a modest amount of interest income and a hedge against bear markets and recessions. So does a third option for getting bonds into your portfolio: guaranteed investment certificates.

For nervous investors who dread a decline in their bond holdings, GICs are a great option. Yields compare extremely well with bonds as sold by an online broker, and deposit insurance is pretty much a given. Expect GIC issuers to either be members of Canada Deposit Insurance Corp. or provincial credit union plans.

Diversified bond ETFs such as the ones I cover in the ETF Buyer’s Guide are arguably the best all-around way to get bonds into a portfolio because they combine decent yields, low cost, transparency and liquidity. But for nervous types, GICs rule.