Misconceptions About Individual Bonds vs. Bond Funds

Investors have been nervous about the possibility of rising interest rates for a number of years now. Since bond prices fall as interest rates rise, this possibility has many investors worried about their exposure to interest rate risk. A common refrain on reducing this risk that I have heard many times over the years goes something like this:

I don’t want to be caught owning bond funds in a rising rate environment. It’s much safer to own individual bonds and simply hold them to maturity. That way I am assured of getting my principal back and not taking any losses.

Sound familiar? I always find it fascinating when investors assume they can completely avoid risk in their portfolio without any ramifications. In this case, the individual bond advocates miss out on a few key points.

Cliff Asness wrote a great piece for the Financial Analysts Journal a few years ago detailing his top ten pet peeves about the investment industry. Number ten was the fallacy that owning individual bonds is really any different than investing in a bond fund:

Bond funds are just portfolios of bonds marked to market every day. How can they be worse than the sum of what they own? The option to hold a bond to maturity and “get your money back” (let’s assume no default risk, you know, like we used to assume for US government bonds) is, apparently, greatly valued by many but is in reality valueless. The day interest rates go up, individual bonds fall in value just like the bond fund. By holding the bonds to maturity, you will indeed get your principal back, but in an environment with higher interest rates and inflation, those same nominal dollars will be worth less. The excitement about getting your nominal dollars back eludes me.

But getting your dollars back at maturity isn’t even the real issue. Individual bond prices are published in the same newspapers that publish bond fund prices, although many don’t seem to know that. If you own the bond fund that fell in value, you can sell it right after the fall and still buy the portfolio of individual bonds some say you should have owned to begin with (which, again, also fell in value!). Then, if you really want, you can still hold these individual bonds to maturity and get your irrelevant nominal dollars back. It’s just the same thing.

I’ve sent this piece to a number of investors over the past couple of years, but most still needed some more convincing. Here are a few more points to consider:

Risk never completely goes away. You’re still dealing with all of the same bond risks as every other investor when you buy individual bonds — interest rate risk, credit risk, inflation risk, duration risk, default risk, etc. It’s just a form of mental accounting to assume that you’ll be able to ignore short-term losses in individual bonds with the knowledge that the principle value will be there at maturity. To which my response is this — if you’re willing to ignore short-term losses in individual bonds, why can’t you ignore short-term losses in bond funds?

Costs and complexity. Buying an individual bond is not exactly a walk in the park. For the most part, they’re illiquid. The costs are much higher to trade. Most of the cost you’ll never be able to quantify because you won’t be able to tell if you’re getting a good deal on your trade or not if you’re not an expert. The spreads tend to be much higher on bond trades than what you see on stocks. You also have to research and understand which types of individual bonds you will be buying. When income payments are made you have to figure out where to reinvest the proceeds. Then you have to figure out what to do with your proceeds all over again when the bond matures.

When do you need the money? Really the only reason that owning an individual bond would make sense is if you needed that amount of money on a specific date. Let’s say you know you need this money in exactly five years for your child’s college education bills.. Sure, maybe then owning an individual bond might make sense. But bond funds are much easier to deal with if you’re slowly accumulating wealth or slowly taking distributions from your portfolio over time. Most people who own individual bonds probably reinvest their principal right back into new bonds, which is exactly what bond funds do.

Diversification. Not only do you diversify your holdings by owning a bond fund, which severely reduces default risk, but you also diversify your cash flow stream. Think of a bond fund like something of a perpetual dollar cost averaging vehicle. In a bond fund you have bonds with different maturities, yields and durations. Most funds hold thousands of bonds so the individual holdings are constantly maturing. This allows bond fund managers to reinvest maturing bond proceeds into the new market interest rates. When rates rise, this is a huge plus for bond funds because they can continuously reinvest at higher rates, which offsets some of the sting you get from the price decline. Yes, you have a maturity date with an individual bond, but this ignores the opportunity cost of investing at higher future rates in the meantime.

I’m all for investors doing whatever they need to do to meet their goals and sleep soundly at night while doing just that. Maybe individual bonds can give some people the peace of mind they need. But I think there are a lot of misconceptions about the differences between individual bonds and bond funds. Investing in individual bonds does not shelter you from risk. Bond funds have risks too, but you may be taking unintended or unnecessary risks by investing in individual bonds if you don’t understand how these things work.

Source:
My Top Ten Pet Peeves (FAJ)

Further Reading:
How the Markets Tempt Us Into Making Mistakes

 

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  1. spazaru commented on Oct 18

    This is great. I’m a novice investor but this will help me when I talk with others about bond funds. I’ve been in several bond funds for years and other folks have told me I’m crazy and I’ve never known how to explain why I don’t think I am. So thanks so much for posting this.

    • Ben commented on Oct 19

      Bonds are definitely more misunderstood by investors than almost any other asset class because they don’t get nearly enough attention as stocks do. No perfect answer or solution here, but it makes sense to understand why you own them in the first place.

    • Ben commented on Oct 19

      very good. thanks for sharing.

  2. SoloCup commented on Oct 19

    Problem with this argument is that a bond fund doesn’t let you schedule your own liquidity events, or ladder them in the way the individual investor needs to. Someone else is driving your train. Add to that the tendency of fund “managers” to load up on high risk paper to spike the yield (which is the first and probably only thing an individual investor looks at in determining the “quality” of the investment) and obscene management and operational fees charged with less than 20% portfolio turnover, it’s clear to me that individual bonds, if you have enough to invest, are clearly superior to any fund.

    • Ben commented on Oct 19

      you can get past these risks by using index or quantitatively managed funds. it really depends what you’re looking for. bond funds provide a constant maturity exposure while individual bonds give you an exact end date. New ETFs that provide a little bit of both as well:

      http://awealthofcommonsense.com/create-bond-ladder-using-etfs/

      All depends on what you’re looking for your bonds to do for you. No perfect answer.

      • SoloCup commented on Oct 19

        Still not optimal. One, you’re limiting a bond investor’s choices to Treasuries. They’ll starve on those yields. The bond world is much larger than that. Secondly, ETFs can be shorted and that could distort values. If an investor has only $5000 to invest, by all means use a fund. It is THAT investor funds were originally targeted for but we lost sight of that once Peter Lynch came on the scene. If you have greater assets to invest, the cheapest, most effective and personally suitable way is from a portfolio of well chosen bonds. Ladder your risk, as well as your yield. Now the investor will get income beyond cat food dinner levels. It’s work, but it’s worth it.

  3. Dividend Growth Investor commented on Oct 19

    I would prefer individual bonds than a bond fund. I am talking about Treasury and Agency bonds.

    I see not reason to pay someone to hold treasury bonds for me ( index or actively managed).

    If I buy an ETF/fund for say long-term bonds like 20 – 30 years, their average maturity will be held constant. This means that the fund will have to sell bonds simply to maintain its average maturity profile. If interest rates are going up, those bonds will have to be sold at a loss.

    If I hold individual bonds purchased today, the quoted value will surely go down as interest rates go up. But I won’t have to sell, and I would use that bond coupon to either reinvest or to spend. At maturity I will get 100 cents on the dollar.

    My goal as an investor is not to mirror some benchmark. My goal is reach my goals.

    • Ben commented on Oct 19

      Well said. My take is whatever works for you. I just think some people don’t understand how bond work.

  4. Jim Haygood commented on Oct 19

    Rarely brought out in the bond fund vs hold-to-maturity debate is the issue of duration. Given typical upward-sloping yield curves, longer-term bonds (5 years and up) on average earn about 100 basis points premium over money market rates.

    Bond funds allow investors to keep duration near their target level: long duration for hedging equity risks; medium duration for maximizing return and Sharpe ratio; short duration for minimizing volatility on funds that may be needed soon.

    By contrast, an individually owned bond goes from (say) a new 10-year issue to essentially a T-bill or corporate paper just before redemption. Not many individuals are actually funding a specific cash flow 10 years hence. Most of them simply don’t realize that during the latter years of their individual bonds’ life, they are morphing into a short-duration investment whose lower return mirrors that of other short-term instruments.

    Sure, individuals can ladder bonds. But that’s what many bond funds do too. Unless an individual has enough capital to do $1 million face value trades on each component of a bond ladder, the extra bid-ask spreads paid likely will equal or exceed the expense ratio of a low expense ratio bond fund of equivalent duration and quality.

    Bonds are traded OTC in a primitive, opaque, high-cost market structure compared to stocks. Liquidity and bid-ask spreads would still be poor, even if the bond market emerged from the 19th century. For small investors, bond funds are nearly always superior to individually-held bonds.

    • Ben commented on Oct 19

      Great points here. I think the constant duration thing is something most investors probably don’t have a great handle on.

      • rbrown04 commented on Oct 31

        Assuming a hold-to-maturity objective, rolling yield convergence for individual bonds and bond ladders compares favorably to yield convergence on a typical bond funds (duration targeted) strategy. Studies over the past decade by Liebowitz et.al. demonstrate this across a broad spectrum of cases, particularly in a rising rate environment. They conclude that:

        “Most investment-grade bond portfolios have stable durations and can be regarded as “duration targeted” (DT). For DT portfolios, multiyear returns converge to the starting rolling yield if the yield curve undergoes a sequence of strictly parallel shifts. The theoretical convergence horizon is one year less than twice the duration target. The laddered portfolios favored by private investors are essentially DT, and surprisingly, their convergence return coincides with the starting yield of the ladder’s “top-rung” bond.”

        See Bond Ladders and Rolling Yield Convergence, Liebowitz, Bova and Kogelman, Financial Analysts Journal, March/April 2015, Volume 71, Issue 2.

  5. BenjaminBrandt commented on Oct 19

    All of the above is true, but creating a non-reinvesting bond ladder for retirement income planning will likely be better than reverse dollar-cost-averaging out of a bond fund when rates eventually rise.

    • Ben commented on Oct 19

      good one. thanks for sharing.

  6. ngbstl commented on Oct 19

    Thanks for another great article. I know that you addressed this a bit in a reader-mail column from a couple years ago (“…Blackrock’s iShares ETF unit now offers bond ETFs with a target maturity date to create an ETF ladder…”, http://awealthofcommonsense.com/create-bond-ladder-using-etfs/), but I wanted to ask for your latest feedback on this approach, i.e. any new thoughts since your original article? (I know Guggenheim Bulletshares are a similar product, but their expenses are considerably higher it seems). Thanks!

    • Ben commented on Oct 19

      I honestly haven’t looked into the issue much since that post. what are the expense ratios on those funds?

      • ngbstl commented on Oct 19

        It seems Guggenheim are about double the iBonds. But *if* one has decided they want to commit some of their fixed-income portfolio holdings to a laddering approach, do you feel the “defined-maturity” ETFs can be useful for that? Or are the expenses and/or NAV premiums not worth it? Thx!

  7. MG commented on Oct 19

    Ben, while what you have written is true, I think you give short shrift to the advantages of owning individual bonds. I am assuming that one is investing at least $200,000 in bonds so that diversification can be obtained.
    1. The biggest advantage to owning individual bonds is that I can control my credit risk, rather than trust some manager who may wish to spike the yield by buying some poorer credits occasionally. I read the prospectus to make certain that I understand what is backing the bond and its risks, and I layer over that a minimum rating from the major credit agencies (in my case, nothing less than AA is acceptable to me). Thus my credit risk is well characterized.
    2. I control the exact duration of my portfolio, and I can alter it when I deem it appropriate. For example, I have recently controlled my longest bonds to only a six year maturity, since I think the FED will start raising rates next year. Since I own a ladder, I only have in my portfolio bonds with higher multiyear rates, since my interest rates stay the same as the life of the bond shortens. That is, I have what are now six month bonds that yield a seven year rate, since I bought them 6.5 years ago).
    3. I can schedule maturities to match certain known expenses. For example, I always have enough bonds maturing in a given year to meet my living expenses, so that if the stock market tanks I will never be forced to sell stocks. Individual bonds with laddered maturities allow me to never have to sell a bond fund at a capital loss.
    4. By waiting and cherry picking the best ratio of interest rate versus risk, I can generate a higher total return than an index bond fund.
    5. I have never lost a penny on my individual bonds since I hold them to maturity, and I expect this will be the case moving forward, even in a rising interest rate environment. The same will not be true for bond funds. Further, in a low inflation environment as is now the case, even in nominal dollars I am likely to be ahead of a bond fund as rates rise due to the Fed normalizing rates (I think we are in for a prolonged period of low inflation).

    This is not to argue against buying bond funds, which are easy to buy and require little time to maintain while holding. Buying individual bonds certainly requires an initial investment in educating yourself, and takes more time and effort than buying a bond fund, but a portfolio of individual bonds can also be tailored to your specific needs and be more profitable.

    • Ben commented on Oct 20

      True, and I think you reinforce the point here that you really have to know what you are doing and have the scale to be able to pull off a portfolio of individual bonds.

    • Grant commented on Oct 20

      MG, I agree owning individual bonds can be a good strategy, but wrt to your point #5 – you will almost certainly not lose money with bond funds in a rising interest rate environment as long as you hold the fund for it’s duration. The initial price drop is recovered due to the higher coupons of the new bonds that are bought at higher interest rates. Owning individual bonds or bond funds is really the same thing. After all, as bond funds are just collections of individual bonds, how could it be otherwise?

      • MG commented on Oct 20

        Grant, that would be correct if none of the bond fund holders sold the fund in the rising interest rate environment. In practice, investors are always selling for various reasons, especially when the bond market is behaving poorly (which it will in a rising rate environment). If there are net sales of a bond fund then the bond fund is forced to liquidate some holdings to pay off the withdrawals. This forced selling locks in the capital losses to bond fund, which results in a lower NAV for all the bond fund holders, even those who hold the fund for its duration.
        On the other hand, if you hold individual bonds, you never have to worry about the foolishness of others’ selling decreasing the value of your bond investment, as long as you follow your original strategy of holding the bonds to maturity, and do not sell any prematurely.

        • Grant commented on Oct 20

          MG, true, any sellers after price drops will lock in capital loses, but if we are talking about a fund of short to intermediate term treasuries, all of which are liquid (so the manager doesn’t have to sell only what he can sell for redemptions), the fund holders that do not sell are not affected by the sellers, and will recoup the loss as time goes go and new bonds at the higher interest rates are bought. Ben, correct me if I’m wrong here.

          • MG commented on Oct 20

            Grant, I am not talking about short to intermediate term treasuries, rather I am addressing other bond markets, such as intermediate municipal bonds. Regarding short to intermediate term treasuries I agree that the risk of loss in a bond fund is negligible, as is the yield. For example, a 5 year Treasury is today yielding only 1.5%. Rather than a Treasury, I would suggest that a FDIC insured CD is a better buy, since you can easily get 2.25% with the same safety as a Treasury. Just be sure not to invest more than the insured maximum of $250,000 in any single account.

  8. 10 Tuesday AM Reads | The Big Picture commented on Oct 20

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  9. VRWC commented on Oct 20

    I’m sorry, but I think you are ignoring a significant risk in owning bond funds…. redemption risk, i.e., the redemptions of other fund holders, over which you have no control.

    While it is true that bond prices and bond fund prices react the exact same way in a rising rate environment, as a bond fund owner you are locked in to the effects of redemption requests by other fund owners.

    If no one sells a fund during a time of rising rates, then a fund will act the same as an individual bond… but if redemption requests come in, then bonds must be sold…. at lower prices…. to accommodate those sales, thus locking in those lower prices for ALL current fund owners, including those who hold tight.

    We saw this happen in the fall of 2008…. back then, faced with redemption requests (and in many cases heavy leverage) some bond funds were selling high quality issues at amazing discounts, because the low quality stuff wouldn’t sell at all.

    I won’t get into specific issues, but I saw, and in a few cases took advantage of, discounts on AA and A rated corporate bonds as low as 79 cents on the dollar.

    Truth is, we have not faced a real bond bear market since the 1970’s…. I am not at all certain that today’s bond investors will be prepared when one finally does arrive.

    • Digitking commented on Oct 20

      I concur but also think the problem is that bonds (especially outside of on-the-run Govts) aren’t especially liquid and there’s problems with NAV reporting. So if a fund holds a bond with a reported price of $95 but then because of redemptions has to sell it at $92, the drop in the NAV hurts all the unit holders.

      This isn’t a big deal in a plain vanilla bond fund but it’s a real issue in High Yield funds and ETFs (or other less liquid parts of the market). Some internal research during the summer showed that the bond prices the ETFs were reporting was significantly higher than what the prices were marked on the bond desk. (in total it was $0.20-$0.50 difference in total fund NAV) So during a panic, funds will likely need to sold irrespective of price or valuation and a significant NAV discount may occur which again hurts everyone.

      • Ben commented on Oct 20

        Of course, but the same problem exists if people are forced to sell their individual bond holdings. Obviously, holding to maturity helps, but my point is don’t put yourself in the position of becoming a forced seller in the short-term (ie, diversify).

        • VRWC commented on Oct 20

          As I said above, any investor can be forced to sell any investment at the wrong time…. but only in a mutual fund are you forced to lose money because OTHER INVESTORS make sales at the wrong time.

      • VRWC commented on Oct 20

        Exactly right… as the old market sages used to say, liquidity is a coward…. it will always run away when you need it most.

    • Grant commented on Oct 20

      VRWC, the issues you describe are a good reason to only own treasuries (safe bonds) to reduce portfolio volatility, and take risk only on the equity side. Then you will never be a forced seller – treasuries will go up during an equity crash giving you capital to buy equities at depressed price.

  10. Strategic1 commented on Oct 20

    But what of the risk of having fellow mutual fund holders demand cash back at a bad time – forcing depressed sales of those bonds (which you might not be able to buy back since the person forcing the prices down is your fund, after which they are again illiquid and not for sale – since the guy who bought them from your fund which had to sell to meet redemptions – knows he got them for a steal?)

    • VRWC commented on Oct 20

      Exactly right…. as a fund owner you have no control over the redemptions of other owners…. and in times of stress and low liquidity, fund managers sometimes have to sell their higher quality holdings at discounts that you would never accept as an individual bond owner.

      • Ben commented on Oct 20

        Sure, but isn’t this an issue with individual bonds as well? If there’s a rush to sell bond fund there will also be a rush to sell individual bonds. If you are a forced seller when bonds are falling you could have some trouble getting the price you think you deserve. That’s how markets work, unfortunately. It all depends on when and why you have to sell.

        • VRWC commented on Oct 20

          But if you are holding individual bonds to maturity, the temporary price declines have zero impact.

          Sure, anyone can need cash at a bad time…. this holds true for all investors in any product.

          But only mutual funds force you to accept the forced sales of other investors at bad prices…. it IS a risk for bond fund holders, just as inadequate diversification can be more of a risk for individual bond owners.

          The two products are NOT identical.

        • jz commented on Oct 20

          As an individual bond holder, when or why would I ever be forced to sell?

        • VRWC commented on Oct 21

          This is an issue with any investment…. if you have to sell when the timing is lousy, that is always a problem.

          But that misses the point…. the problem with bond FUNDS is that you are at the mercy of your fellow fund owners…. if you are smart enough with individual bonds, and build a ladder where something is always maturing, you have no problem.

          But if you own bond funds, in a rising rate environment, you are at the mercy of your fellow bond fund owners…. you get locked in to the lower values of their poorly timed sales, and lose money even if you have no need to sell yourself.

        • James MacDonald commented on Oct 21

          I think the larger point is the changes in portfolio construction that can occur under heavy redemptions. The fund manager will almost surely sell bonds that are of lower risk, because they will be less impacted by rising rates. So you can have a bond fund change composition, and the NAV be even further impacted just because of the rush for the exits by your fellow investors.

          In other words, when a fund manager needs to sell bonds to fund redemptions, he or she may be forced to sell the higher quality bonds, because the lower quality or less liquid bonds are, well, less liquid, or are too impacted by the rising rates to make it worthwhile to sell. If this goes on for any length of time, your bond fund that was primarily investment grade corporates may change to have a much higher proportion of high yield bonds than you care to have.

          In addition, bond funds are often not really funds of bonds, but instead a mixture of bonds, forwards, swaps, and other hedges that may or may not react the same to a rising rate environment as a bond ladder.

  11. Doug01 commented on Oct 21

    Assume I’m retired (I’m not). Money I need for the next year is in cash equivalents. Money for the three years after that is in a ladder of individual bonds. Assume these are government bonds, so there is negligible credit risk. Assume I’ll hold each bond to maturity, so there is no interest rate risk or liquidity risk.

    The only two risks left are inflation risk and reinvestment risk. And if I buy zero coupon bonds, there is no reinvestment risk. So that leaves inflation risk, which is a very significant risk, but one also shared by bond funds.

    With my bond ladder, my future income and return of principal are known.
    Compare that to a bond fund: my future income and return of principal are unknown.

    The advantage of bonds, as an asset class over stocks, is the certainty associated with them. By buying bond funds, you have lost that advantage,

    For short terms bonds, it probably doesn’t make much difference whether you buy a fund or individual bonds. And there may be cost and convenience advantages associated with bond funds, versus individual bonds.

    But here is where the individual investor may have an advantage over the institutional investor. The individual can buy CDs, a bond equivalent in many ways, that the institution can’t. And those CDs may generate a greater return than bond funds

    • Ben commented on Oct 21

      True, I failed to mention CDs, many of which you can buy with decent yields and very low early exit penalties (so they have negligible int rt risk if you want to get out when rts rise). Your example makes complete sense to me. I’m not saying don’t own individual bonds. But you could also buy SHY, IEI & IEF and create a fund of bond funds with different durations/yields. It all depends on what your end goal is.