When it comes to the fixed income portion of your investment portfolio, you have a choice between individual bonds or bond funds. While they appear to have similar characteristics, the truth is they’re quite different. This post explains the pros and cons of individual bonds and bond funds to help you understand which might be best for your financial situation.
First, what is a Bond? A bond is simply a contract between the issuer and the holder. Issuers can be corporations, governments, and municipalities. The issuer is contractually obligated to pay the holder (investors) an annual stream of interest income and the principal at a later, specified date. If the issuer defaults, the investors seek recourse through the courts. A bond fund (mutual fund or ETF) simply pools hundreds of individual bonds for convenience and diversification.
Now that we understand what a bond is let’s take a look at the characteristics, features, and benefits of individual bonds vs. bond funds. Investors allocation to “fixed income” may or might not be “fixed” depending on the investments you hold. With individual bonds the income is fixed: investors can plan on a set, known amount of income from their individual bond holdings. However, a bond fund lives on in perpetuity and is being traded and managed constantly. Therefore, the interest paid is not known and can change from month to month. Thus, a key difference in owning a bond vs. a bond fund is whether you’re looking for “fixed” income or “variable” income.
Another key difference between the two relates to “safety.” As stated previously, assuming the issuer does not default, an individual bond investor is assured their principal back at maturity. With a bond fund, no such promise can be made. If investor A buys a quality 5 year corporate bond for $20K he or she will get their $20K back in 5 years, including the interest. If investor B purchases a corporate bond fund for $20K he or she may or may not get their $20K back in 5 years. The difference is for a couple reasons: 1. As stated, the bond fund manager is buying and selling bonds on the open market and thus might lock in gains or losses. These gains or losses are reflected in the fund’s NAV (net asset value) price. This characteristic resembles a stock more than a bond. And 2. Bond prices fluctuate with interest rates. As interest rates rise, bond prices fall. As interest rates drop, bond prices rise.
During the most recent financial crisis many bond funds dropped in value. Here’s a list of a few large bond ETF’s and their respective draw-downs from just one month in 2008 (Sept.9th-Oct.10th).
|iShares Barclays MBS Bond (NYSE: MBB)||-3%|
|Vanguard Total Bond Market (NYSE: BND)||-9%|
|iShares Barclays TIPS (NYSE: TIP)||-10%|
|iShares Barclays Aggregate Bond (NYSE: AGG)||-13%|
|iShares iBoxx $Invest Grade Corporate Bond (NYSE: LQD)||-19%|
|iShares iBoxx $High Yield Corporate Bond (NYSE: HYG)||-26%|
Source: Yahoo! Finance.
Those are fairly significant losses in just one month from a supposedly “safe” investment. And when volatility strikes like this, bond funds face another crucial risk: Redemption Risk. Redemption risk can happen when investors panic sell, forcing the bond fund manager to sell bonds in the pool in order to meet cash reserves required to meet the needs of those investors wanting out. In times of high volatility and panic, much of these bonds are sold at loss to the fund.
In summary: bond funds offer broad diversification, convenience, and the ability to invest in smaller dollar amounts. The distributions can be re-invested and have the ability to “grow” the NAV per unit. However, the income is not set or known. I believe bond funds are good for younger investor’s portfolios. Though we own them in our portfolios, we have stop losses in place and indicators to get us out when necessary. For retirees and pre-retirees, owning bond funds for income and or in perpetuity could be a dangerous choice.
Individual bonds on the other hand, allow for retirees to plan on and budget for the income received. And because they can hold the bond to maturity, get their principal back. Many retirees like the convenience of knowing what they own, what they can expect, and control the choice of whether to sell or hold to maturity. Additionally, by using a bond ladder, we’re able to mitigate default and interest rate risk in our client’s fixed income portion of their portfolios.
There’s a lot to know in this great debate and the short post here covers only the basics. If you have additional questions or concerns about your specific fixed income portfolio, please reach out to me. Let’s talk about the risks you might be taking and how best to reduce those risks.