Individual Bonds or Bond Funds?

Individual bondIs 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.

Eliminating interest rate risk?

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.

Eliminating credit risk?

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.

Treasury Bonds

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

  •  they save the mutual fund fees
  • If you buy at auction there are no bid-offer spreads to worry about since none will be incurred
  • for taxable accounts there is the ability to tax loss harvest at the individual security level, something you cannot do with a mutual fund
  • You can target the specific maturity and cash flow you want, something harder to do with mutual funds

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).

Municipal Bonds

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.

Summary

Here are some things to consider when deciding which route to take:

Individual Bond

  • High bid/ask spreads (up to 500 basis points. And you may never find out what it is)
  • Interest rates go up, bond price goes down
  • Most bonds are not very liquid; thus creating higher costs to buy and sell
  • you can sell bonds whenever you want (to harvest tax losses to fit your need)
  • you can hold the bonds to maturity
  • No management fees
  • You decide what credit rating of the bond is acceptable
  • Reinvestment risk. You may not be able to reinvest interest at the same rate as the bond
  • You can pick the maturity

Bond Mutual Fund

  • Instant diversification. Good for small investors.
  • Bond funds can usually get better prices because of quantity discount
  • Bond funds provide liquidity
  • Bond funds provide reinvestment of interest
  • Bond funds may generate capital gains taxes
  • Credit ratings of bonds may not be what you want
  • No bid/ask spread
  • Annual expense ratio (up to 1%)

Bond ETF

  • Low bid/ask spreads (around 5 basis points)
  • Unlikely to generate capital gains tax
  • Low annual expense compared to bond mutual fund

Treasury Bonds

  • No state, local tax
  • No bid/ask spread
  • No management fees
  • No brokerage costs when bought from the gov't
  • No credit risk thus diversification is unnecessary
  • No minimum number of bonds to purchase
  • No reinvestment capability of interest
  • Very low bid/ask spread in the secondary market
  • You pick the maturity of the bond

Municipal Bonds

  • About 90 times less likely to default than corporate bonds (i.e. historically low default risk)
  • Markups increase with smaller lot sizes
  • Most bonds trade infrequently
  • Have at least $500,000 worth of muni bonds to be diversified
  • You pick the bond maturity

Resources

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.

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