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Should you buy bond funds or individual bonds?

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AUTHOR: Jonathan Clements on 4/04/2021
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tshort
9 months ago

Bond funds – government bond funds (munis or fed) can be a good source of tax-free income in a taxable account. This can be particularly useful when you are still earning income, you’re looking for the asset allocation stability that bonds are generally used to deliver, and you’re trying to keep taxable income low.

Individual bonds – again, government bonds like TIPS, T bonds and T bills are useful when capital preservation becomes important, usually after you retire, and you’re looking for tax effective source of passive income. In a ladder, these become a great way of annuitizing a part of your portfolio to protect against sequence of return risk. Each year a rung on the ladder matures, providing you with the option to either use it to spend when the market is down, or reinvest it when you’re decumulating from your portfolio. The big brokerage firms all sell bonds on the secondary market and they only charge a couple basis points above market asking price. Very reasonable, liquid, and easy to do.

Rob Jennings
9 months ago

We hold about 50% bonds in retirement divided almost equally between an individual TIPs ladder and a few bond funds, both of which serve different purposes. The 10 year TIPs ladder is the foundation of our strategy as each TIPs is liability matched against a future annual gap between income and expenses. Both bond and stock ETFs/funds get rebalanced into the TIPs ladder. TIPs are not that difficult to buy occasionally and while they do have tax challenges, they are the only tool which provides guaranteed future purchasing power which outweighs the downsides in our case.

Cammer Michael
1 year ago

When rates are up, bond funds are attractive. When rates drop, collect capital gains and get out.
Otherwise, avoid them.

Charles Burks
1 year ago

Anybody who was paying attention in 2022 should realize that there is a downside to bond funds over individual bonds. As a US Federal employee I have access to the G fund in the TSP (Federal 401k equivalent). That has no duration and cannot lose value, and provides yields similar to Treasury Bills. Outside of that, I had a bond fund (Vanguard BND) that took a 15-20% dive at the same time that large cap and total market indexes (Vanguard VTI) took a similar dive. So much for non-correlated investments and spreading risks. That got me to finally pay attention to the mechanics of investing in treasury notes. It seems a lot safer than a bond fund, and it appears that doing so is more tedious than complex. My wife and I are pre-retirees and still pressed for time and attention, so she uses a SPDR short term treasury ETF in the hope that it’s the next best thing to actually taking the time to build a T-Bill bond ladder.

booch221
1 year ago
Reply to  Charles Burks

Owning individual bonds does not really reduce your risk. The value of a bond that you buy direct from the will decline in value and you would take a loss if you had to sell it before maturity. If you hold it to maturity you get all your money back, but if you own an index fund they will hold the bond to maturity too and you will still collect the interest every month.

I lost about 15% on my Vanguard bond fund last year but the individual bonds in the fund still pay the interest and as the low rate ones expire they are replaced by higher rate ones.

Last edited 1 year ago by booch221
tshort
9 months ago
Reply to  booch221

Agree, Charles. Lucky you, having access to that government employee fund. That sounds excellent.

Booch221 – see my full comment above.

jerry pinkard
1 year ago

I sometimes buy US treasuries direct, but otherwise bond funds. I do not have the expertise nor want to spend the time determining the best bonds. As I understand it, the spread between buy and sell can be pretty wide, and is another disincentive to buy bonds (except treasuries issues).

Roboticus Aquarius
2 years ago

I believe in simplicity. I use bond funds. Convince me that individual bonds are likely to give me a substantial benefit in terms of return or reduced risk, and I might consider changing my approach… other wise I’ll just keep it simple.

Jim Burrows
2 years ago

Depends on why you are buying bonds.

The main concern with bond funds is that you cannot be sure that you will recover principal in full when you need to sell. If you don’t want to lose any part of your principal and want to be certain to earn the coupon, then own a ladder of individual bonds. You will also avoid all fund expenses.

Thomas McGlinchey
3 years ago

HD recently posted about the use of iBonds from Treasury Direct. They should be looked at in terms of investing your cash that is not tax-deferred. My use of bond funds is to constantly ensure that in retirement I will have sufficient cash to withdraw funds to make my RMD. Having needed cash available via TD and iBonds that are held long enough is something I can deal with. I haven’t had to mess with them since the kids are now grown and have families of their own. The HD article is worth reading. I hope it was HD 🙂

Kurt S
3 years ago

Don’t buy any bonds. Social Security will be your fixed income source. Today, if I was collecting Social Security (my goal is to wait to age 70), the income generated each month would be like owning over $2M in a 10-year bond that also gives a cost of living raise sometimes. That is an insurance policy guaranteed by the govt. printing press.

Mike Zaccardi
3 years ago

Bond funds.

A bond fund is simply a basket of individual bonds securitized in a low-cost way. People get caught up in interest rate risk and say foolish things like “a bond fund has an infinite duration” which is just not true. While a bond fund’s NAV will go down as rates rise, maturing bonds get replaced with higher rate bonds, so the yield to maturity rises. Thus, rising rates are actually a good thing for fixed income investors over the long haul. You’d rather have a 6% current yield than a 2% CY, right?

And individual bonds require more leg work and trading effort. Not to mention possible liquidity issues.

Andrew F.
3 years ago

I don’t have the knowledge to decide which individual bonds are most appropriate for my situation, so funds and ETFs are an easy choice. And the bonus is that the risk is spread out so much more widely.

Sanjib Saha
3 years ago

I have mixed feeling about owning individual corporate bonds. I had setup a ladder with A and above issues. There were a few unexpected downgrades (due to M&A), and a few got called away too. I remember getting stuck with a few issues that I no longer wanted to keep, but the liquidity weren’t great and I had a hard time in disposing them. Too much effort for too little gain. I haven’t had any problem with individual Treasury as they are highly liquid.

Target-maturity funds (bullet funds) are handy for ladders – the fees are reasonable given the benefits of issuer diversity and much better liquidity. I have separate funds for short and intermediate terms, and both inflation-protected and regular ones. I think the convenience of funds outweigh the hassle of managing individual issues.

I had better luck with individual preferred shares (non-Bank), especially the cumulative ones with favorable tax treatment. Most of them were bought during market shocks and at a nice discount to par. The income is decent. I don’t intend to sell them anytime in foreseeable future, though a few got called too.

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