Individual Bonds or Bond Funds?

February 5, 2018  | By Kevin Smith

Bonds do not get a lot of attention in conversations because they are both complicated and boring, but they are one of the three primary places to hold money that you have not spent. Those are currency, bonds, and equity (stocks and real estate). This is a brief review of bonds with an emphasis on the common debate about whether to own individual bonds or bond funds.

We cannot expect bonds to build wealth over time, so we have to rely on stocks and other equity assets to build long-term wealth. There are basically two reasons to own bonds:

1) You need to spend the money in the next five years or so, you do not want to risk that it won’t be there when you need it, and you would like to keep pace with inflation along the way.

2) You are uncomfortable having all of your funds exposed to stock market risk, so owning some bonds decreases your risk exposure (decreasing your stress).

Helpful hint: instead of thinking in terms of ‘buying bonds’, substitute the concept of ‘making a loan’. When you buy a bond, you are making a loan. You gather interest on your loan over some period of time and then get your money back at the end, assuming the borrower can repay you.

Once we decide how much to have in bonds and learn about their risk factors, the next decision is how to own them. This can be done by either buying individual bonds or buying a fund that owns many bonds on your behalf.

Here is the reality as I understand it: owning several individual bonds is not fundamentally different from owning a mutual fund that contains many bonds. Each form of ownership has risk, return, cost and liquidity characteristics. The differences lie in your exposure to each of these. Here is a rundown…

Both have default risk. Individual bonds can default and not repay you. Bond funds are diversified, usually containing hundreds of bonds, so the risk is usually lower. Diversification wins.

Both have interest rate risk. When interest rates go up, the market value of bonds goes down. Necessarily. The market value of the bond then moves back up toward the ‘par value’ (the original amount of the bond contract) until it achieves par value and matures (pays out the contract value). This risk is true of both individual bonds and bonds held in funds.

CAUTION: Common wisdom suggests that individual bonds are safer because if interest rates go up, sending their values downward, you can just wait until maturity and get your money back without selling at a loss. This is true, but the economic result is the same as if you sold at a loss prior to maturity and reinvested in new bonds with higher interest rates. The loss of principal is offset by higher interest payments. There is no meaningful difference.

Both have costs of purchasing and owning. All individual bonds are bought and sold through brokers and the ‘spread’ assessed by a broker can be 1% to 3% (or more) of the purchase price. Bond funds purchase large quantities of bonds at much lower spreads and can operate at lower costs even after considering management fees. Lower fees win.

Both require reinvestment decisions. The interest paid by bonds will sit in cash until it is reinvested. As mentioned above, the cost of buying small quantities of individual bonds can be outrageous. Bond funds can reinvest interest payments systematically at very low costs. More efficient reinvestment wins.

The MAIN reason to own individual bonds: if you need your money to be available on a specific date, you can buy a bond that matures on that date. This situation is more common for institutions than for individuals.

A quick recap on the basic concepts investors should know about bonds…

1) Know the reason to own bonds.

2) Get comfortable with how much of your portfolio should be in bonds.

3) Understand the risks of owning bonds.

3) Know the most effective way to purchase and own bonds.