By: Investor Solutions, Inc.
Before we can answer the question “should you invest in individual bonds or bond mutual funds”, we have to first understand the purpose of owning bonds in your portfolio. Novice investors use bonds as an income generator, relying on yields to supplement living expenses during retirement. Institutional investors and competent advisors, on the other hand, view bonds as a tool to reduce portfolio volatility. Total return, not just bond yield, is what counts. If the purpose of holding bonds is to control portfolio risk, then owning bond funds, not individual bonds, is the appropriate choice.
Individual bond shares are not cheap. A single corporate bond can cost you $10,000 or more. So, if a retiree with a million dollars decides to allocate 40% of his portfolio to bonds ($400,000), he would likely have to purchase at least forty different issues to achieve a somewhat diversified bond portfolio. The higher costs associated with acquiring individual bond issues may prevent many investors from sufficiently diversifying among different issues.
In contrast, an initial investment in a bond fund might cost only $1,000 to $3,000 depending on if you purchase it in a retirement account or not. As a bond fund holder you can own stakes in dozens, perhaps hundreds, of bonds with one purchase. Let’s take for example the Vanguard Short Term Bond Index (VBISX). If you own an IRA, you can hold 642 distinct bond positions with a $1,000 investment in the funda far cry from the 40 issues we purchased in the previous example.
While individual bonds do not incur the ongoing management and operating expenses of bond funds, they do have associated expenses (including brokerage commissions/fees and bid-ask spreads) that all investors should consider. Furthermore, retail investors (as most of us are) get less favorable pricing (commissions AND bid/ask spreads) than institutional investors. The costs of trading individual bonds are very hard to accurately pin down and commissions are never fully disclosed. If ever there was an area for institutional traders to make obscene profits in the markets, it’s the bond market.
When you purchase a bond fund, you know what the cost will be: a transaction fee and the expense ratio. There are a handful of low priced bond funds available, including the Vanguard Bond index we discussed above whose annual expense is only 0.20%.
Many investors are under the impression that owning bonds is a risk-less transaction. That is a myth that results in a false sense of security. The fact is that bonds, whether corporate or treasury respond to daily changes in interest rates as well as credit conditions. Individual bond investors might take comfort in knowing that at the end of the maturity period, their principal will be returned. However, throughout the maturity period, their principal will fluctuate. As interest rates rise, bond principal will go down (since the bonds become less attractive to new investors). If the owner of the individual bond feels compelled to sell their position before the maturity date, they may likely take a loss during a period of rising interest rates.
Bond funds are much more liquid. Granted, bond funds do not have a fixed maturity (meaning principal nor income is guaranteed). But, fund managers are constantly buying and selling bonds within the portfolio in order to maximize interest income and capital gains.
Additionally, if you only own forty bond issues in your portfolio, having one or two of them default can put a serious damper in your day. In contrast, because a bond fund holds hundreds of bond issues, if a handful of them default the impact might be nonexistent.
The Benefits of Indexing
By now I hope I’ve convinced you that bond funds are more attractive than individual bond issues. But, what type of bond fund should you buy?
There is a strong argument in favor of owning bond index funds instead of actively managed bond funds. In general, bond index funds offer you broad bond market exposure for a fraction of the cost of an active fund. All other things equal lower expense ratios result in higher returns for you. Furthermore, with actively managed funds, investors assume an additional level of risk: manager risk.
In conclusion, there are distinct benefits to owning bond funds in lieu of individual bonds. Despite their ongoing expense, bond funds provide a better alternative in terms of diversification, liquidity, and the availability of reinvesting dividends. A low cost low cost bond index fund will help you achieve the portfolio risk control you need. Remember, just as with equity investments, the more broadly you diversify, the better results you will attain.