Bond Talk: Funds vs. Individual Bonds
It's once again time for Bond Talk, where we answer your questions about what's happening in Bond World.
Question #1: Was the release date for "No Time to Die" (the new Bond flick) pushed back again?
Unfortunately it was. Expect to see the film in theatres on October 8th, 2021, pushed back from April.
Question #2: Are individual bonds less risky than bond funds?
It’s a fair question. Individual bonds come with a strong promise that you’ll get your principal back at maturity. Bond funds don’t have that guarantee. (Let’s assume no risk of default.)
So does this guarantee mean you’ll make more money, or have less risk, by owning individual bonds vs. bond funds? Particularly in a rising interest rate environment?
Nope, that’s a myth. Getting your principal back at maturity adds no economic value compared with a mutual fund.1
How is that so?
For starters, bond funds are really just portfolios of individual bonds. If interest rates go up, the price of bonds goes down. It doesn’t matter whether those bonds are owned by themselves or as part of a fund.
Let’s say you bought an individual bond with a 2% yield and a five year maturity, for $10,000. By the time the bond matures, yields have risen to 3%. True, you didn’t lose money in a “nominal” sense—you invested $10,000, and got the same amount back.
Now let’s say, instead of buying the $10,000 bond, you invested in an intermediate-term bond fund, with a steady duration of around five years. When you invested in the fund, the yield was 2%, just like the individual bond. But as rates rise, the fund’s yield adjusts quickly to the new rate environment, reinvesting cash flows into new bonds that have higher yields - adding to returns.
Five years later, which would be worth more, the individual bond, or the bond fund?
The difference probably won't be significant, and at least one research study shows that bond funds have an advantage.2
In the long run, the difference in performance between a portfolio of individual bonds and a bond mutual fund with the same duration and credit quality, held for the same amount of time, is likely to be small, because most of what an investor gets out of investing in bonds is the income from coupons, rather than the price change.3
Now let’s turn to an equally important question. What are the advantages of bond funds over individual bonds? That’s pretty easy to answer.
Diversification – Bond funds typically own hundreds, if not thousands of issues, providing instant diversification. Further, investors can easily access multiple areas of the bond markets through funds—diversifying into U.S. Treasuries, agencies, corporate bonds, municipal bonds—quickly and easily.
Better Pricing – Fund managers buy bonds in large quantities and receive better prices than individual investors buying smaller sizes. Beware the broker's “I don’t charge a commission on bonds” claim. Commissions are there, you just don’t see them—your yield is reduced.
Liquidity – Bond funds offer near instant liquidity, making it easy to add money or take money out when needed. With individual bonds, you need to either wait for maturities, or risk taking a “haircut” by selling smaller bond lots at poor prices.
Reinvesting – Bond funds pay out interest in the form of monthly dividends, making it easy to reinvest, vs. waiting for the semiannual coupons of individual bonds to add up to enough to make it worthwhile to buy another bond.
There are circumstances where owning individual bonds makes sense, and investors with significant resources can achieve scale in an individual bond portfolio that mitigates some of the disadvantages. But for most investors, bond funds (and that includes ETFs) are a great solution.
Question #3: Is that cool Bond car back?
Looks like it! The No Time to Die trailer highlights Bond's iconic Aston Martin DB5.
David Rappaport, CFP®
David is the Co-Founder of Rappaport Reiches Capital Management. He acts as personal CFO to entrepreneurs and corporate executives, providing organization and clarity in their finances. Please connect with David below. He loves to talk about investing, financial planning, and Aspiritech, a non-profit hiring individuals on the autism spectrum.
1. A topic of current interest: Bonds or bond funds? Vanguard Research, 7/17
The author does not intend to provide investment, legal or tax advice as these materials are for general educational purposes only. Please consult your legal, tax or investment professional for advice on your particular situation. This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. It is not intended to be a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction. Investing involves risk including the possible loss of principal. Past performance does not guarantee future results. Please refer to RRCM’s Form ADV Part 2 for additional disclosures regarding RRCM and its practices.