Owning Individual Bonds vs. Owning a Bond Fund

A reader asks:

I’ve been minimally invested in bonds as a long-term investor but if I can get 5% or more interest, I’d love to allocate funds and lock that in for as long as possible. I’m looking at corporate investment grade new issues and they largely seem to be callable in a year. While I would be happy if rates came down and I got my principal back in a year, I’d also be happy holding them if they are not called and I keep earning the less competitive, but acceptable coupon. I’m anticipating bond index ETFs won’t compete on yield over the next year with their current basket full of low coupon bonds until they mature and are replaced over time. Can you speak to the intelligence (or counterargument) of buying individual bonds in today’s market if an investor feels investment grade has acceptable credit risk and wants competitive yield short or more ideally, long term (vs. dividend or bond ETFs)?

I’ve written a lot about finance over the years and certain topics can ruffle people’s feathers more than others.

Most financial decisions exist in a state of gray but many people think only in black and white about things like passive vs. active, paying down your mortgage vs. investing the money, the Federal Reserve, the CAPE ratio, crypto, etc.

The one that surprised me the most was individual bonds vs. bond funds.

Lots of people have very strong feelings about their bond strategy.

Allow me to lay out the cases for and against holding a portfolio of individual bond securities.

If you buy an individual bond from a broker and hold it to maturity, you will receive regular income payments from that bond based on the yield when you bought it.

Then at maturity, you will receive your full principal back. A bond is simply a debt instrument so this makes sense.

Let’s say you put $10,000 into a 5-year U.S. treasury bond that yields 4%. You would receive $200 every 6 months and your initial $10k at maturity in 5 years (assuming you purchased it when it first came to market).

Simple enough.

The reason many people like holding individual bonds like this is because they know exactly what they are going to get and when.

Even if rates move up or down in the meantime, you can wait out those fluctuations and still receive par value at maturity.

After experiencing big losses in their bond funds this year, many investors are wondering if they would have been better off holding individual fixed-income securities.

This sounds like a good idea at first glance but does not hold up in reality.

Why is this?

Bond funds literally hold individual bond securities that are marked to market every day.

How can a fund of individual bonds be better or worse than an individual bond that you hold?

“Getting your money back” at maturity might be a wonderful emotional hedge but it’s not like you’re any better or worse off.

When rates go up, the value of all bonds goes down, whether you’re holding an individual bond or a bond fund.

While holding to maturity does allow you to get your principal value back at par, in an environment of higher rates and inflation you will still be getting back nominal dollars that are worth less at the time of maturity.

For example, let’s say you own a bond fund that yields 2% and rates go to 4%. If the duration of those bonds is 5 years, you would expect that fund to fall something like 10% in value.

Not fun.

For the sake of this example, let’s say you then decided to sell your bond fund but then buy all of the individual bonds in that fund which now collectively yield 4% and hold them to maturity.

Are you better off now or not?

No – you’re in the exact same place either way!

Now let’s say you own just one 2% 5-year bond and rates go to 4%. Sure, you do get your money back at par if you just hold until maturity but now you’re earning 2% less per year than the current market rate of 4%.

So you could sell that 2% bond at a loss to move up to one that now pays 4% interest. But you’re going to lose either the principal value if you sell or the income if you hold the bond that pays a lower rate.

This is just how bond pricing works. There are no free lunches here.

Having said all of that, there are still some pros and cons of each approach because of how most bond funds are managed.

Buying individual bonds:

  • Could lead to higher trading fees (usually paid in the form of bid/ask spreads).
  • Typically requires more money (depending on where you’re trading).
  • Makes it much harder to diversify your portfolio.
  • Makes it harder to rebalance your portfolio.
  • Adds an additional level of complexity to the equation if you don’t know what you’re doing.
  • Could lead to a constantly changing risk profile in terms of maturity and duration as your bonds get closer to maturity (although some investors utilize a bond ladder to make this more constant).
  • Can offer investors some peace of mind about interest rate changes (even if it’s more about emotions than math).
  • Can make it easier to match assets with liabilities.

Buying bond funds:

  • Gives your professional management and economies of scale in terms of trading costs.
  • Comes with an annual expense ratio.
  • Offers lower minimums to invest.
  • Makes it easier to diversify and rebalance.
  • Gives you the ability to set a constant maturity and duration profile (since most bond funds have target maturity levels).
  • Doesn’t guarantee all bonds will be held to maturity since there is some turnover involved.
  • Can make it more difficult to match assets with liabilities.

So there are some differences here.

A lot of it comes down to your tolerance for complexity and ability to understand what you’re doing if you try to manage a portfolio of individual bonds yourself.

Most investors don’t have the ability to do that.

In terms of competitive yields for individual bonds vs. bond funds — higher yield almost always means higher risk.

You can get somewhere in the range of 5-6% yield to maturity in most high-grade corporate bond ETFs right now. Anything more than that in individual bonds would imply higher risk.

When buying corporate bonds that risk could come in the form of a credit downgrade or a possible default. Those risks are why some bonds pay higher rates than others.

It probably depends on how comfortable you are in buying individual fixed-income securities and how dependent you are on giving yourself an emotional hedge in bonds.

We discuss this question on the latest edition of Portfolio Rescue:

Kevin Young joined us again this week to respond to questions about owning bonds vs. beaten-down tech stocks, saving for your children, how longevity should factor into retirement planning and how your finances change when you begin making more money.

Here’s the podcast version of today’s show: