FREE NEWSLETTER
INVESTORS WILL OFTEN tout the benefits of individual bonds, while disparaging bond funds. Why? Owners of individual bonds not only avoid fund expenses, but also enjoy a comforting degree of certainty. If you buy a seven-year bond, you know how much interest you will receive each year and what sum you’ll get back when the bond matures in seven years. By contrast, if you own a fund that focuses on bonds with an average maturity of seven years, you can’t be sure how much interest you’ll collect each year or what your fund shares will be worth seven years from now.
But the greater certainty offered by individual bonds is something of an illusion. While holders of individual bonds know their bond’s nominal value at maturity, they don’t know the inflation-adjusted value, unless they buy inflation-indexed bonds. Moreover, if interest rates rise, both individual bonds and bond funds will fall in value, and holders of both could potentially lose money if they’re forced to sell.
In addition, the performance difference between the individual bond and the fund likely won’t be that great—and the individual bond comes with greater risk. If you purchase an individual bond, you’re making a big bet on a single issuer, while a fund offers broader diversification. That big bet could come back to haunt you.
On top of all that, when ordinary investors buy individual bonds, they’re often charged huge markups, though you can sidestep this problem by purchasing new issues. A bond fund, meanwhile, should benefit from institutional pricing. Funds are also easier to buy and sell, plus you can reinvest your fund distributions in additional fund shares, no matter how small those distributions are.
That ability to reinvest is a key advantage, especially when interest rates climb. Yes, rising interest rates will depress the price of both individual bonds and bond funds. But with a fund, you can easily take advantage of those higher rates by reinvesting your distributions in additional fund shares.
Next: Buy a House?
Previous: Indexing Dangerous?
Articles: Question of Interest and Certain but Risky
A bond fund resembles a floating rate perpetuity, Its dividends will reflect the average coupon of its holdings. As the fund is periodically rebalanced towards its target duration the average coupon of its holdings will change, rising when rates go up and vice versa, This is couterbalanced by the falling prices of the bond portfolio due to higher rates. Which of these two effects predominate at a certain time depends on the coupons carried by the bonds and on the extent of the change in rates, Therefore the return on the fund is mostly uncertain for a planned horizon.
As someone who has a 1/99 AA heavily invested in individual municipal bonds, I take great exception with most every point raised in this article. The author makes assumptions on most points, apparently without having any personal first-hand experience. On the other hand, I do have significant first hand experience, and have outperformed VBTLX (as well as Bloomberg Municipal Bond Index) by a wide margin over any time period you’d like to compare – YTD, 1 year, 3 years, 5 years, 10 years.
That’s an odd point to make – because a bond fund holder certainly doesn’t know her inflation-adjusted value at any point in the future either.
I know what I am doing, and that’s why I do what I do.
The greater certainty offered by individual bonds is not something of an illusion whatsoever. However, the more folks who actually believe this, and simply throw their money into bond funds, the better, as it will keep more retail investors out of the (municipal) bond market and not bring additional competition for me.
There are moments — such as a sudden rise and sustained higher level in interest rates — when trading a bond fund for individual issues can have an additional benefit. A large bond fund will take quite some time to turn over its holdings of lower coupon bonds for new, higher-paying ones. I personally wouldn’t consider doing this with anything but Treasurys.