Rising Rates: Bonds or Bond Funds

(Look – I don’t know if interest rates are going to go up this year.  They might.  They might not. A prediction about the near-term direction of interest rates is NOT the intent of this piece.)

Whenever there is a hint that interest rates will start to rise, brokers and some advisors start unfurling the banner of:

“Individual bonds are better than a fund in a rising rate environment!”

Of course what is meant is “Individual bonds PERFORM better in a rising rate environment,” since that is what we’re all here to talk about: performance of investment portfolios and the impact of that performance on an individual’s or family’s wealth.

This (flawed) argument goes something like this:

When interest rates rise, bond prices go down. Owning individual bonds is good in this environment because you will get your principal back at maturity, which doesn’t happen with a bond fund.  For this reason you should own a portfolio of individual laddered bonds.

Psychologically, investors (and some advisors) love the feeling of this maturity process. It feels “safe.”   The bigger question, though, is: What do you do with the principal that you receive back at maturity? If you are a long-term investor and you own a laddered bond portfolio, you are most likely buying a new individual bond at the far end of your ladder (perhaps 5-10 years out in maturity).

Of course, this exact action occurs on a very regular basis inside a bond mutual fund or ETF. In fact, it is happening much more frequently, because the fund owns hundreds or thousands of individual positions, and most investors likely do not own more than 25 individual bonds in a laddered portfolio. The fund receives the bond principal back at maturity and subsequently reinvests the proceeds.  In a rising rate environment, proceeds can be reinvested at higher yields.

Choosing to own a portfolio of individual laddered bonds presents the investor with a number of risks that are mitigated by a fund:

  1. Diversification (or lack thereof).  Generally speaking, individual bonds trade in lots of $5,000.  Yes, you can buy a single individual bond, but typically you will own at least 5-10 bonds per position ($5,000 to $10,000 face value). So even the wealthiest of investors are unlikely to own more than 50 individual bonds, as this is a significant monitoring burden for the investor or advisor. A broadly diversified bond index fund can easily own over 2,500 bonds. Less diversification for the individual bond investor can mean higher credit (default) risk, sector risk, or in the case of municipal bonds, more geographic and political risk, and a less frequent maturity schedule.
  2. Trading costs. The economies of scale inside a fund give the vehicle a tremendous advantage when trading as compared to an individual investor. Bond funds are buying hundreds or thousands of bonds at a time, and the individual is buying 5-10. This gives the fund leverage when trading, cost savings that can be passed to the individual investors. Individual investors buying a ~$10,000 position are going to see bigger bid/ask spreads and higher commission costs to buy. The chart below, from Vanguard, shows how significant these trading costs can be to individual investors.  The smallest investors paid 1.40% more for a bond than the largest purchases, costing the investors 0.60% in yield.bond bid ask spreads
  3. Individual portfolios are exposed to as much real-time volatility as a fund.  While the promise of a future payment of principal exists in a portfolio of individual bonds, the portfolio will still rise and fall in value with changes in interest rates in between these maturity dates.  When rates increase, bond values will still fall based on their maturity and exposure to interest rate risk. Individual bond investors reviewing their brokerage statements will be no less insulated to these falling values than those who invest more efficiently through funds.

The goal for an investor (and his or her advisor) ought to be to maximize the efficiency of portfolio returns by minimizing the costs of investment intermediation so that the investor can keep more of the market return.  Individual bonds can increase portfolio risk and certainly increase the costs of investing.

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