Bond Funds vs. Bonds

Note: This post was originally published in September 2009; however, the below still has relevant principles.

Please read an updated version here. https://www.henssler.com/individual-bonds-vs-bond-funds-whats-the-difference

Many individual investors choose to gain exposure to fixed income investments through the use of mutual funds and Exchange Traded Funds that invest in bonds. While bond funds are appropriate for some investors, many who invest in bond funds or ETFs that invest in bonds may be missing out on two key characteristics that owning a bond provides: a fixed yield and a contractual maturity date. Does it really matter if you own a bond directly or own it indirectly through a pool of bond holdings? An investor must ask himself what he seeks to accomplish by owning fixed investments. Let’s take a look at the advantages and disadvantages of each strategy.

Bond Funds

Advantages:

Diversification:
Owning a bond fund or ETF that invests in bonds gives an investor the ability to pool their resources with other investors. This pooling of resources allows for more bond issues to be owned, and thus spreads the risk over more holdings (i.e., each individual investor owns a small percentage of a larger number of bond holdings).

Professional Management:
Mutual funds are structured so that all the investors’ money is pooled into one master account. Then a portfolio manager will actively manage this pool of cash. A bond fund is a mutual fund that invests primarily in bonds and other debt investments. The bond market is a lot larger and less organized than the stock market. Professional managers backed by a strong research staff can put the time into researching the investment merits of each bond, which in theory should lead to better purchasing decisions.

Easy to own:
A major advantage in buying bond funds, or ETFs, is their ease to purchase and the ease of managing. You do not have to focus on research of the individual issue nor do you have to haggle with your brokerage firm to seek best pricing. You invest your money and the fund manager handles the sausage making.

Disadvantages:

Cost:
All of the above advantages come with a cost. The cost is the annual expense ratio. If you are going to hire a company, or person, to manage your bond portfolio, you will have to pay a fee. Some bond funds charge a sales commission at purchase, while other have a back-end sales charge when you sell. This is in addition to the ongoing annual fund expense.

Act Like Stocks:
Bond funds are not bonds! A key disadvantage to owning bond funds is that a collection of bonds with constant maturities loses most of the attractive characteristics fixed income securities offer. When you own a pool of bonds that are constantly maturing, the value of the portfolio is based on the market value of the bonds in the portfolio at any given time. When you own a fund, the portfolio manager rarely holds the underlying bonds to maturity. Therefore, the consequence are the fixed income portfolio trades like a less volatile stock with limited upside and unlimited downside risk.

Uncertain Income:
When a pool of bonds pays interest, the interest is deposited into the master account that holds all of the investors’ cash and investments. The portfolio manager charges a fee to the master account for managing the investments. The portfolio manager takes their fee first, then passes along what is left. A recent example is the iShares Treasury Inflation Protection ETF (TIP). This ETF pays monthly interest and tracks the Treasury Inflation Protection Securities of a variety of different maturities. Although the underlying bonds continued to accrue interest, this ETF failed to pay an interest payment to its investors from November 2008 through March 2009. Just because the fund owns or tracks bonds that pay interest, does not mean that interest will be paid to the investor.

Floating Rate:
The yield on a bond fund “floats” with market yields. As rates fluctuate, yields on bond funds do the same.

Individual Bonds

Advantages:

Cost:
When you own individual bonds, you do not have to pay a fund expense charge. However, if you use a broker or an investment adviser, they can charge you a commission or advisory fee to purchase and monitor the bonds for you.

Less Volatile than Stocks:
Bonds have several components that make them different than real estate, commodities or stocks. When you buy a bond, you pay a purchase price in return for a stated interest rate for a defined time horizon. At the end of that time horizon, your investment is returned to you. Ownership of individual bonds ensures that you retain the key characteristics of bonds.

Income Clarity:
Bonds are a contractual obligation of the issuing company. Since the bond you own has a stated rate of interest, you will receive an interest check based on the terms of the bond, unless the bond defaults. It is a lot easier to manage an income stream when you know how much interest you will be paid and for how long.

Disadvantages:

Harder to Diversify:
Unlike a stock that can be bought for $35, most bonds have face values that range from $1,000 to $100,000. It is more difficult for an individual investor to build a diversified portfolio of bonds. Buying high-quality bonds can mute the volatility of limited diversification, but it will cost you in lower yield.

Pricing:
Bonds are priced based on a spread. The trader or broker makes their money on the spread. Unless an individual is investing a large amount of money, it is more difficult for individuals to obtain the pricing a bond fund manager may be able to get (i.e., smaller spread). Buying in lots of 100 (i.e., $100,000 face value) is the best way to minimize cost.

Another factor to consider is that in periods of high economic stress, bond funds have been a poor protector of asset values. Take this recent downturn as an example. Many bond funds that consider themselves short-term or stable bond funds were down more than 10%, while other bond funds that invested in corporate debt or mortgages were down 25% to 50% in most cases. The S&P 500 was down 37% over the same time frame. Asset allocation gets a black eye in times like this.

Over the long term, bonds are a poor investment vehicle when principal appreciation is your goal. Think about what a bond is. It is a debt instrument that some government or company issues to raise money. They promise to pay a interest rate for some time frame and return your money at the end. Bonds have limited upside with an unlimited downside. You can lose your entire investment if the bond defaults. It is also highly unlikely that a quality bond will ever double in value.

Bottom Line

Henssler Financial recommends individual investors own individual bonds. The ultimate reason you would own a bond is to provide for a known cash need. If you need to buy a new car for $40,000 in the three years, you should own a high quality bond that matures close to the three year mark for $40,000. If you try to accomplish this matching of liabilities and assets with a bond fund, or ETF, you have no idea what the value of your investment will be in three years, because bond funds do not mature. For more information on bonds or bond funds, please contact Henssler Financial at 770-429-9166, or experts@henssler.com.