Is it best to buy individual bonds are a bond fund? There are compelling arguments for both.
Here are the two perennial arguments:
Bond funds eliminate credit risk: One should own bond funds in order to build a more diversified portfolio. Owning even a couple of dozen individual bonds exposes the investor to undiversified credit risk if an issuer defaults.
Individual bonds eliminating interest rate risk: One should own individual bonds because bond funds give an unnecessary risk in that their value moves with interest rate changes. If interest rates go up, the value of the bonds and bond funds go down. But if you hold the individual bonds until maturity, in a laddered portfolio, you eliminate this risk since they generally mature at par. No such guarantee exists with funds since they are constantly buying and selling additional bonds.
The argument that holding a bond to maturity eliminates interest rate risk is completely false. Here is why:
You buy a one-year bond today for $1,000 that promises to pay back $1,050 in one year. The interest rate is 5 percent ($1,050 - $1,000)/$1,000. The value of the bond today is $1,000, calculated as follows:
1,050/1.05 = $1,000
After buying this bond, assume inflation kicked in and the same bond is now yielding 6 percent. A new bond would now be paying $1,060 in a year. The bond you bought, however, is giving you back only $1,050, so now the value of your bond today is calculated as follows:
1,050/1.06 = $990.57
Or, a decline of $9.43 from the $1,000 you paid.
Because interest rates went up by 1 percent, the value of your bond dropped by $9.43 or 0.94 percent. If you keep the bond for the entire year, you’ll get $1,050 back. Remember that the new bond is paying 6 percent, so you missed out on buying the $1,000 bond that would have paid $1,060, or an additional $10.00. So, holding onto the bond has an opportunity cost of:
$10/1.06 = $9.43
As you can see, holding a bond to maturity provides no protection from interest rate risk.
An additional benefit of bond funds - liquidity
Bonds are still not as liquid as an open-ended no-load bond fund. A no-load bond fund can be sold without a cost. Even a bond ETF can be sold at a minimal cost and the bid-ask spread is usually less than 0.05 percent, or five basis points.
However, individual bonds can have bid-ask spreads of fifty to five hundred basis points (5 percent). You will have no idea that you are paying these hefty fees to the market maker because they are not disclosed.
Most bond funds reduce credit risk but there are several things to consider. Individual Treasury bonds have zero credit risk; municipal bonds have very low credit risk compared to corporate bonds (historically, 90 times lower). With an individual bond ladder you can sell only the ones with losses, while with a fund you can also be selling bonds that also have gains in them. This is a big advantage of individual securities.
Diversification is only needed when there is
unsystematic/uncompensated risk, risk that you can diversify away
and therefore are not compensated for taking.
With Treasury securities there is no need for diversification as there is no credit risk that you can diversify away. Thus, a buyer of individual Treasury bonds gets several advantages
And since the evidence shows that corporate bonds have provided very similar returns to Treasuries (credit risk has not been rewarded appropriately) there is little if any need to buy corporate bonds. And that eliminates the need for bond funds, except for small accounts, or for those that value the convenience of funds.
With Treasuries even small amounts are okay, just as it is with CDs (because there is no credit risk)--the issue is then one of convenience and costs (if any).
With municipals, if you stick to the highest investment grades the need to diversify is greatly reduced as municipals are about 90x less likely to default than similar highly rated corporate bonds. That doesn't eliminate the need to diversfy, but it greatly reduces it. In other words, you don't need to own hundreds of bonds, but a few dozen might be enough, if you stick to AAA/AA and avoid risky sectors like health care related bonds. The lower the credit rating the more you need to diversify. Thus investors with a large enough portfolio can do so on there own in relative safety and with lower costs and the other advantages. Small lots increase bid/ask spreads.
Here are some things to consider when deciding which route to take:
Individual Bonds - Learn about individual bonds: due diligence, risk, advantages, and much more.
Bond mutual funds - Learn about bond fundss: due diligence, risk, advantages, and much more.