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BONDS MAY NOT BE the most interesting investment, but they generate their fair share of debate. Especially after 2022’s rout, when total-bond market funds dropped 13%, many investors wonder how best to proceed. An open question: Does it make more sense to buy individual bonds or opt for bond funds?
To answer this question, let’s start with a simple example. Suppose you’d invested in Vanguard Group’s total-bond market fund (symbol: BND) on Jan. 1, 2022. As of today—two and a half years later—that investment would still be down more than 5%, even including the interest income received along the way.
It’s because of depressing results like this that many investors argue in favor of individual bonds. Because bond issuers promise to repay investors in full when they hold a bond to maturity, buying individual bonds seems like a no-lose proposition and an easy way to avoid the losses inflicted on bond fund investors.
This, however, isn’t an apples-to-apples comparison. Suppose that on Jan. 1, 2022, you’d purchased a collection of bonds that mirrored the holdings of the bond fund described above. It’s true that, if you held all of those bonds to maturity, you’d indeed avoid losses. But that’s not the right comparison, because it overlooks the value of those individual bonds today. If you tried to sell them today, you’d realize a loss in the neighborhood of 5%, matching the cumulative loss in a comparable fund.
In other words, there’s no mathematical difference between a bond fund and a collection of individual bonds that matches the holdings of that fund. It’s only when bonds are held to maturity that they can help investors avoid losses.
Like everything in personal finance, though, there are caveats. For starters, bond funds—like all funds—carry costs. But bond fund fees tend to be modest, so I don’t see this as a significant factor. And because the bond market, unlike the stock market, doesn’t operate with quoted prices, there can be significant trading costs when buying individual bonds. Bond fund managers, with their dedicated trading teams, will generally do better than individual investors. That arguably can offset a fund’s fees and thus I wouldn’t let cost be a deciding factor.
A more important issue is the risk inherent in any mutual fund. Being an investor in a fund is like being a passenger on an elevator with other people. Everything ought to be fine—as long as everyone else behaves. It’s the same in a mutual fund. Your fate, to a degree, is dependent on your fellow shareholders.
That’s because, when a fund is having a challenging year, some investors will head for the exits. That can force the fund’s manager to sell part of the fund’s assets at depressed prices, locking in losses. That loss is then shared pro-rata among all fund investors. With a portfolio of individual bonds, you don’t face that risk. You have the ability to hold on through tough patches and avoid locking in losses.
Individual bonds carry other benefits. Key among them is the ability to lock in current interest rates. With today’s rates at levels that we haven’t seen in more than 15 years, this is a valuable opportunity. You could build a ladder of bonds going out 10 years and lock in rates in the 4% to 5% range. It would be difficult to achieve this level of precision with a bond fund or combination of funds.
Another way in which individual bonds can be beneficial: Suppose you’re in retirement and withdraw $50,000 per year from your portfolio. A ladder of $50,000 bonds maturing over the next five to 10 years can simplify portfolio management. Each year, you’d simply withdraw the proceeds of the maturing bond. While less common for individual investors, this is a bedrock strategy employed by insurance companies to ensure they always have the funds for future claims. In fact, it’s a key reason many insurance companies have been in business for 100 years or more, so it has a lot of merit.
At the same time, funds offer benefits of their own. At the top of the list is simplicity. Because the bond market is so much larger and more diverse than the stock market, buying bonds takes work. Depending on the type of portfolio you want to construct, it can also be difficult to achieve sufficient diversification. And if you build a ladder, it will require further time and effort to reinvest the proceeds as bonds mature.
So, does it make more sense to buy individual bonds or opt for bond funds? I favor a hybrid approach.
I’d include a mix of short- and intermediate-term maturities. That’s because short-term bonds offer greater stability when interest rates rise, while intermediate-term bonds provide greater appreciation potential when rates drop. What about long-term bonds? This is a corner of the bond market that I wouldn’t include, because of its volatility.
For exposure to short-term bonds, I’d opt for funds, owing to their simplicity and liquidity. Which funds? Because they’re backed by the U.S. government, my first choice would be U.S. Treasurys. If you’re in a high tax bracket, you might also include some municipal bonds.
For intermediate-term exposure, I recommend a mix of bond funds and individual bonds. That’s because funds offer simplicity—they’re easy to buy and sell for withdrawals or rebalancing. But only individual bonds offer the ability to lock in rates, as described above, and this could be a great benefit when interest rates drop, which will likely soon happen, or so the Federal Reserve recently telegraphed.
What else might you include in a bond portfolio? I’d own some inflation-protected bonds, such as Treasury Inflation-Protected Securities (TIPS). According to research by Vanguard, short-term TIPS are the most effective type of bond to guard against inflation, so that’s what I recommend.
Among the thousands of bond funds available, which should you choose? Just like with stocks, I tend to prefer index funds. This is an area, though, where there’s a significant difference between stocks and bonds.
The data tell us most actively managed stock funds lag their benchmarks. But it’s a different story in the world of bonds. According to a recent survey conducted by research firm Morningstar, nearly three-quarters of actively managed bond funds beat their benchmarks over the past year, so I wouldn’t necessarily exclude an actively managed fund from consideration.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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That’s interesting about actively managed bond funds. I would ask two questions before investing though.
1) what is the expense ration?
2) what is the turnover rate?
That’s a pretty short time frame to base a conclusion on. How have actively managed bond funds done over the last 10 years compared to their benchmarks? How much better did they perform?
You can get numbers from S&P’s SPIVA study. There’s a summary of the results here:
https://humbledollar.com/money-guide/mutual-funds/
What are the way that BND will recover its losses?
The same way individual bonds recoup their losses: The bonds in BND will continue to pay interest and, if the bonds are below par value, that discount will narrow as each bond’s maturity approaches. In addition, in the short-term, bond values may be boosted by falling interest rates.
I found Edward Chancellor’s book “The Price of Time” (a history of interest rates over the past 5,000 plus years, recommended by Bill Bernstein) to be a fascinating read. More detail than I need, so I skimmed much, but very enlightening.
No mention of individual bonds’ default risk? I’ve had them go south.
And in the initial comparison of individual bonds vs a fund purchased in 2022, a fairer evaluation would have made the comparison when the individual bonds matured, not just two years later. Bond funds don’t just sit there, they buy new issues continuously. Whether this helps or hurts, I don’t know, but fair is fair.
From my readings because bond funds are constantly buying new issues it helps when rates are going up interest wise, however as I learned in ‘22 the value of the previous bonds decreases. The reverse is true when rates decrease.
Since I invested a significant amount in Vanguard Intermediate Bond Fund in January of ‘20 my return is 0.1%.
From my readings because bond funds are constantly buying new issues it helps when rates are going up interest wise, however as I learned in ‘22 the value of the previous bonds decreases. The reverse is true when rates decrease.
Since I invested a significant amount in Vanguard Intermediate Bond Fund in January of ‘20 my return is 0.1%, with a total capital los of >17K.
OUCH!
I have just started looking into etfs like Ishares defined term treasury bond funds such as IBID and IBTI. Has anybody else looked into or invested in similar funds and if so do they ameliorate any of the possible negative issues Adam raised about more traditional bond funds?
Yes, I bought IBIK for the first time in early July. David Enna’s post on Tipswatch in late May informed my thinking. I plan to hold the 10 years to maturity.
https://tipswatch.com/2024/05/30/ishares-launches-its-2034-target-date-tips-etf/
Some of the big brokers offer separately managed accounts (SMA) including for bonds. This could be a compromise between both worlds, as you don’t have to research and manage individual bonds yourself, yet your “fund” isn’t subject to the “next door neighbor risk” of your fellow shareholders wanting to exit the fund. In this case, your bond SMA will own different bonds than anyone else’s as it is based on available inventory when you fund it. This allows the managers to only sell should you need liquidity or if there is a reason to sell a bond to purchase another. It’s almost like being the only shareholder of your SMA.
Interesting. Something I should look into.
Like many, my wife and I have discussed the question of ‘when to retire’ over the past few years. There are many things to consider and this subject is well documented on HD. One question which doesn’t seem to get much air time for a couple is “will both partners agree on the answer to the question?”.
For my wife and I, one subject that required a meeting of the minds, was agreeing on financial plan for our future selves.
I had developed a detailed plan and associated spreadsheets and developed this plan over several years. But any financial plan requires assumptions to be made. Our conservative plan assumed that our IRAs will grow annually on average at 5%, that the 5 years of cash/savings we have on hand will grow 2% annually, annual inflation for expenses growing at 2.5% and me taking SS at 70, my wife at 62. We have a detailed list of current expenditures and made allowance for plenty of margin for error, so that unknowns (e.g. inflation spiking) will not catch us off guard, we can maintain our current lifestyle and allow us to travel etc.
All the analysis shows that our future selves will be just fine financially with some left over for the next generation.
The big question for my wife, what if the 5% growth assumption in reality is 0% or less? While history has shown that the stock market grows over time, in the short term there are periods of drawdown and low or negative growth. What if the U.S.A. is the next Japan? What if Bonds get hammered (2022). What will that do to the plan?
Me answering “stay the course, we will be fine” wasn’t a good enough answer for my wife to forego her bi-weekly pay check. Even though I believe I am conservative in my planning, my wife was quite rightly making a risk assessment and wanted a plan where she could also ‘buy in’ and sleep at night.
This conversation was reaching a crescendo in the fall of 2023. At this time, long term 10 and 20 year US treasuries were delivering around 5% yield to maturity. My wife asked, if our financial plan assumes 5% return, and we can get that return for 10/20 years, will treasuries help our financial plan become more certain and reduce risk? Long story short, we compromised on purchasing 10 and 20 year treasuries which account for approximately 15 years of future expanses. The balance of retirement funds remaining in low cost stock index funds, so that we can also capture growth assuming the markets deliver long term growth.
As an example, on October 20th, we were able to purchase 10 year 5% yield to maturity US Treasuries with 4.125% coupons via our Schwab account. The $100 treasuries were discounted to $93.74 to achieve the 5% yield. In addition to receiving the coupon every 6 months, as interest rates have fallen since October, the price of the same treasuries has risen ‘on paper’ to $102.72 (9.59% increase) as of the close on Friday. We have the option of reinvesting the coupon received in stocks or bonds, or using it as income in the future. If the Fed acts to reduce rates in the next year or so, we have the option of locking in the ‘on paper’ gains understanding that over time the price of each Treasury will migrate back to $100 the closer we get to maturity. If the Fed acts aggressively the ‘on paper’ returns could be significant. If the stock market corrects significantly we have the option of converting a portion of the Treasuries to stocks, provided the shift still meets our long term goals. I am not into ‘market timing’ but understand that every once in a while the stock market sells off significantly and provides an opportunity. Having ‘dry powder’ (US Treasuries) on the sidelines returning 5% in the meantime doesn’t hurt.
Thanks for sharing your journey and plan. Mine is very similar (though I wasn’t lucky enough to “lock it in” when interest rates were at their recent peak). The only risk I see is persistent high inflation. But your taking SS at 70 and investing the balance of your IRA in low cost stock index funds should help mitigate this. At least, that’s what I hope for myself…
Good article explaining pros/cons. I try to keep it pretty simple for myself, a total bond etf, short-term TIPS etf and a rolling five year CD ladder.
Very informative, thanks. Question: Are individual TIPS complicated to evaluate and buy? I’m leaning toward a TIPS fund in my IRA but as an alternative could buy an individual TIPS or a defined maturity TIPS fund.
Like many, I suspect, I’m reevaluating my tactics with bonds. Individual Treasurys and CDs held to maturity have served me well since 2022. But if short rates are going to fall … do you lock in yield before the expected September rate cut? Or try to ride price appreciation in a fund? Also, with focus now on economic weakness, I may need to rein in my corporate credit exposure, which has crept up this year.
TIPS are easy to buy at auction at Fidelity and Vanguard, and I suspect Schwab also. See tipswatch.com for auction previews.
TIPS are also easily bought at auction at Schwab. I do, however, think buying previously issued TIPS is “complicated.” You might want to do this if you are building a ladder and, say, want a bond maturing in 3 years.
Thanks for this clear explanation. This helps me understand the world of bonds a bit better.
Jonathon, thank you ! I suspected some type variance from the benchmarks, and you certainly explained it perfectly.
In times of recession, etc., I suspect that those index beating bond gurus will have a swift reversal of fortune.
I will stay with the strategy of taking minimal risk with my bonds, treasuries of short duration only, and use ultra low fee stock indexes.
It appears that chasing performance will never go extinct. If it seems too good to be true and so forth.
Thanks so much again, you helped me to no end, again.
I also wish for your health struggles to hopefully turn positive.
I just set up a five year CD ladder, using brokered CDs at Vanguard. Would a bond ladder have been better, and if so, why?
I’ve heard that some brokered CDs may contain a call provision which the issuer would more likely exercise in a declining rate environment. Have you experienced any brokered CDs being called prematurely?
I did something similar 2 years ago, but used CDs for years 1 and 2, the US Treasury Notes for year 3. Not sure if this was any better, but wanted the option to sell the Notes, without penalty, if needed. I also maintain about a years worth of expenses in a high yield money market fund.
That’s an interesting question. I don’t own any individual bonds but do have a few brokered CDs. One concern I have is liquidity…not sure whether the secondary market actually exists if I had to sell a brokered CD prior to maturity.
I wonder why so many actively managed bond funds are doing so well, beating the benchmarks, are not bonds the same as stocks, as far as being a ” zero sum game?” or less, due to trading costs and fees ? for every buyer there needs to be a seller, etc.?
Do you think that this outperformance will continue? If all of that trading is done in conventional accounts, are higher tax bills in the equation, are there costly bid-ask spreads, and so forth?
Hopefully, someone on this site will write an article with more detail on the subject, soon! The Wall Street Journal recently wrote an article saying the same basic thing, and many investors extolled the recent virtues of buying junk bonds, MBS bonds, etc.
To all of the many whom are far more astute than me, please provide more information , details, data, et. al.
Now, on to a far more understandable subject for me,than bonds, namely, Einsteins ” On The Electrodynamics of Moving Bodies”, followed by ” Is The Inertia Of A Body A measure Of Its Energy Content?”. ( I am trying to be humorous, of course. I am clearly no match to Einstein, or even Larry Fine, of ” Three Stooges”, fame.)
I suspect part of the issue is that, with so many different bonds trading and only a small portion included in the indexes, it’s easy for managers to “cheat” on their benchmark index by reaching for yield with lower quality securities. Such risk won’t always pay off, but it would in periods of economic prosperity.
Can you guarantee yourself that you will receive the posted interest rate of a bond fund on the day that you invest if you hold that investment in the fund as long as the “average effective maturity” (AEM) of the bond fund? In other words, is holding a bond fund for the length of its AEM the same as holding an individual bond to maturity?
No, there are no guarantees — though the total return on the bond fund will be very similar to the total return on an individual bond of similar maturity. But here’s what amuses me: Buyers of individual bonds love to tout the certainty offered by individual bonds, and yet — unless you’re buying inflation-indexed bonds — you have no clue what your after-inflation return is going to be, so isn’t the certainty offered by individual bonds yet another example of a financial illusion?
You might not know the after inflation value, but if inflation comes in hot, wouldn’t you do worse in a fund? Maybe it depends on the holding period.
Not sure why you would think a bond fund — which simply holds individual bonds — is somehow going to be inferior in an inflationary environment or, quite frankly, any economic environment. Again, I think we’re in money illusion land. Folks assume that the purported certainty of individual bonds also means they’ll magically perform better.