Bonds vs. Bond Funds

Bonds vs. Bond Funds

A friend of mine was shocked when his “safe” bond fund fell in value as rates shot up after the Fed raised interest rates. He had to delay buying the new car. The fund wasn’t as safe as he thought. The value of his investment depended on future interest rates and on when he needed the money. Many investors do not really understand the main difference between bonds and bond funds.

Bonds mature. Bond funds do not.

Bond funds are managed to an index that likely has no relevance to our personal situation. I generally prefer individual bonds for this simple reason.

When I purchase a bond, I know exactly when my principal will be returned, assuming the issuer does not default. I can estimate my income, understand my interest-rate risk, and know that risk declines as the bond approaches maturity. None of those things is true of a bond fund.

The Problem with Bond Indexes

Most bond funds are managed relative to an index, with the most widely followed benchmark being the Bloomberg U.S. Aggregate Bond Index, commonly known as “the Agg.”

The Agg was originally developed to measure the performance of institutional fixed-income portfolios. Market lore holds that Art Lipson and John Roundtree at Kuhn Loeb devised the earliest version of the Agg for Connecticut General Insurance to measure how well the insurance company managed its general account. They created an index of every bond the insurer could buy. Today, the index broadly represents investment-grade U.S. taxable bonds meeting minimum size and liquidity requirements.   As companies issue bonds, they get added to the index. This results in heavily indebted companies being given greater weight. The U.S. government is the index’s largest borrower and therefore receives the largest weight. First question for me and you as investors, “If the index did not exist, would you tell an advisor to put 50% in Treasuries,12% in BBB…? Perhaps. But those weights would reflect your goals—not the borrowing decisions of issuers.

In addition, many bonds in the index are callable, meaning issuers can repay investors early when interest rates decline. This limits upside while preserving downside risk.

The first strike against many bond funds is that they are managed against an index that may have little relevance to an investor’s actual objectives.

That does not mean bond funds are inappropriate. Investors seeking total return may find them entirely suitable. Managers such as Bill Gross and PIMCO demonstrated for decades that active bond management can add value, and the Agg remains a useful benchmark for measuring performance.

Why Maturity Matters

The primary advantage of individual bonds is certainty.

If I buy a five-year Treasury today, I know that in five years I will receive my principal back, along with the coupon payments earned along the way. Barring default, there is no mystery about the outcome.

A bond fund is different. Even if the fund has an average maturity of five years today, it will not mature in five years. The portfolio changes as bonds mature and as newly issued bonds are added. The value of the fund at the time I sell depends entirely on prevailing interest rates and market conditions.

The risk profile can also change significantly over time. Over the past fifteen years, the duration, the sensitivity to interest rates,  of the Bloomberg Aggregate Bond Index has ranged from roughly 3.5 years to more than 7 years. In effect, the benchmark’s interest-rate sensitivity nearly doubled between 2010 and 2022.

The Hartford assembled a chart showing that the index’s duration has increased as rates have declined — meaning the index’s risk has risen over time. Duration is a quantitative measure of interest rate sensitivity. By contrast, if you buy a seven-year bond, its duration steadily declines toward zero as it approaches maturity. Your risk decreases with time. You have locked in a return.

As interest rates declined, the index’s duration increased, meaning investors were taking substantially more interest-rate risk than before. Credit risk can also change as bonds enter and leave the index or as issuers are upgraded and downgraded.

Matching Bonds to Your Goals

The appropriate fixed-income strategy depends on why you own bonds in the first place.

If your goal is total return, bond funds may be entirely appropriate.

However, many investors own bonds for different reasons:

• Generating reliable income
• Funding a future liability
• Preserving capital
• Providing stability during stock market declines
• Maintaining an emergency reserve

For these investors, a benchmark such as the Agg is less relevant than a specific maturity target.

Suppose you know you will need $50,000 in five years to purchase a car. In that case, owning bonds that mature when the cash is needed may be more appropriate than owning a perpetual bond fund.

Similarly, investors who view fixed income as their emergency reserve often benefit from the predictability of Treasury securities, CDs, or a bond ladder tailored to their time horizon.

Before buying any bond, understand how much its price is likely to decline if interest rates rise by 100 basis points. If that potential loss makes you uncomfortable, shorten the maturity.

The Case for Bond Funds

An economist I worked with once said to me, “I do not understand why government bond mutual funds exist. There is no credit risk in a U.S. Treasury. Just buy a Treasury with a duration and maturity you are comfortable owning.” That comment cuts to the heart of the matter.

Mutual funds exist to solve the problem of owning a diversified portfolio with limited capital. To own every stock in the S&P 500 individually would require over $5 million and constant rebalancing through dividends and spin-offs — impractical for most investors. Replicating the Bloomberg Bond Index individually is even more challenging. Bond fund managers generally replicate and manage the risk characteristics — maturity, sector, industry, credit rating — of their benchmark index.   Mutual funds provide low-cost access to professionals who can manage these characteristics, perform due diligence, and, in active funds, make over- and underweights relative to the benchmark.

You get bond diversification for less than it would cost to buy one bond.

Alternatives to Traditional Bond Funds

Investors who prefer the certainty of maturities but want professional management have several options.

Separately managed accounts (SMAs), now widely available through brokerage firms, can build customized portfolios of corporate or municipal bonds within defined maturity and credit-quality guidelines.

Defined-maturity bond ETFs offer another attractive alternative. These funds hold bonds that mature in a specified year and liquidate at a predetermined date, providing many of the benefits of individual bonds with the diversification of a fund.

A bond ladder can also be an effective strategy. By staggering maturities across multiple years, investors gain liquidity, reduce reinvestment risk, and avoid making large bets on the future direction of interest rates. A few firms now offer ladder ETFs that provide professional management with the certainty of an ETF at a low cost. (On June 11, Vanguard announced laddered corporate ETFs for a fee of just 8bps.)

What About Buying Individual Corporate Bonds?

Buying individual Treasury securities is straightforward because there is essentially no credit risk beyond that of the U.S. government.

Corporate and municipal bonds are more challenging. Most of us lack the expertise of professional credit analysts to evaluate default risk, covenant protection, or municipal finances. As a result, they often rely heavily on ratings from Moody’s and S&P.

For investors venturing beyond Treasuries, professional management, SMAs, or diversified funds often makes sense.

Whichever route you choose, always understand the fees, taxes, risks, and expected yield after costs. Before investing in fixed income, ask yourself a simple question: Do I want maximum total return, or do I need a specific amount of money at a specific future date or might I need this money for an unexpected expense? Unless it is the former, individual bonds, bond ladders, CDs, or defined-maturity ETFs may be better tools. The best fixed-income investment isn’t the one that tracks an index. It’s the one that matches your goals

Matt Halperin, CFA, is the founder of Act2 Financial, an app that helps seniors avoid financial fraud. For 30 years, he worked as a portfolio manager and risk manager at large U.S. money managers. Matt currently serves on the investment committee of two endowments.  He has a BA and MBA from the University of Chicago, and resides outside of Boston.