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Individual Bonds Versus Bond Funds

Previously, I wrote about safe investments including the various types of funds, and the general case for having bonds in your portfolio. Today, I want to write  about where you would use an individual bond versus a bond fund. Now, let me start with a disclaimer, I personally alternate between the two depending on what is advantageous to my situation, but there are some very real arguments for leaning one way or the other.

Individual Bonds versus Bond Funds Simplicity

The most basic reason to stick with a bond fund is that they are simple. Especially if you’re investing in an index fund, you don’t need to worry much about investigating the health of the bond you’re investing in. Check the rating breakdown, and away you go. An individual bond, however, like an individual stock, is not a diversified position. Thus, if you’re investing in bonds as a smaller investor (someone who can’t duplicate an index of them), then you need to do your research on what you’re buying. You simply can’t trust the rating agency values of a single bond like you can in aggregate. So frankly if you don’t have the time or wherewithal to investigate the financial stability of a single bond issuer, then you’re better off staying in bond funds.

Individual Bonds versus Bond Funds Return

A individual bond, unlike a bond fund, has a set income. You can count on it to deliver the same income before adjusting for inflation from month to month when held to maturity. You know when you buy it that it will return it’s interest rate plus or minus any change from it’s face value if you hold it to maturity. A bond fund, meanwhile, is a collection of bonds which means it’s an average of all bonds in the portfolio. Furthermore, in the case of a mutual fund you have no control over if they hold the bonds to maturity or cash out. If people sell their shares then the fund will be forced to sell bonds before they mature, potentially losing some principle in the short term based on fluctuations in the given market.   The individual bond would also lose this principle but since it was not sold it would be only a paper loss.  Over the long run this should mostly balance out as additional deposits in the bond fund can be invested at a higher yield which is the entire reason the fund’s net asset value would have dropped in the first place.   The higher yield should offset the lost existing principal.  However, these issues do collectively lead to inconsistency of bond fund income from period to period.

Individual Bonds versus Bond Funds Liquidity Issues

Many individual bonds have low liquidity. This means the volume sold on the open market is low, and there tends to be a high spread for these items. Spread in this case means the difference between the value of the bond and what is paid for it. This spread is an inefficiency that increases with lack of liquidity and can cost you dearly depending on how illiquid the security is. Bond funds meanwhile sell at their Net Asset Value, or the value of the underlying assets, so there can be no spread. Bond ETFs may have some spread, but even for larger indexes it is likely to be small as the volume of sales is larger. So if you think you will need to sell a bond before maturity you’re probably better off in a fund for most offerings. There are some exceptions to this with higher volume instruments like treasury bonds.

Individual Bonds versus Bond Funds Fees

Needless to say bond funds and ETFs have a yearly expense fee you do not encounter with an individual bond. However, in order to get diversification from single bonds you have to buy many of them. Typically this will involve some sort of trading acquisition cost, especially if bought on the secondary market (items resold after original issue). As such costs may be a wash over time depending on the types of bonds and funds.

Individual Bonds versus Bond Funds Diversification

Finally Bond Funds provide superior diversification over single bonds. Bond funds allow you to hold a wide range of bonds at once. You can replicate this holding individual bonds but it gets expensive quickly. Most bonds sell in quantities of 1 thousand. Obtaining diversification across a wide swath of segments of the bond market (different maturity stratifications and the like) will likely require you to have over $100K invested in individual bonds. There is one exception to this.  If you are investing in Federal government bonds there is no reason to diversify, as default risk is essentially zero.

My Individual Bond versus Bond Fund Holdings

As noted from the beginning, I mix and match Bond and Bond Funds. In general, I hold some individual largely tax exempt bonds of high quality in Delaware State Municipal issuers that exceed the return of my mortgage. I have heavily researched these holdings financial positions. Furthermore, given the size of the state of Delaware my holdings are likely not much less diverse than the tax exempt funds focusing on my state. We talked previously about why tax exempt funds should be focused on your own state so I won’t belabor the point. Still I am taking a risk. These are just a very small portion of my safe holding portfolio. For the portion of safe holdings that I do hold in bonds, the bulk are in funds.

Do you hold individual bonds or bond funds? Why did you go one way or the other?

14 Comments

  1. Smart Provisions
    Smart Provisions March 3, 2017

    Thanks for clarifying the differences between an individual bond vs a bond fund.

    Currently, I hold a small percentage of my portfolio in bond funds. The reason I did this is primarily for diversification and because I’ve been a bit lazy on researching and learning up on individual bonds.

    I don’t foresee myself getting too much into individual bonds as I would have to plan out which bonds to pick and make it diversified. I would probably stick with bond funds until I have a better idea and knowledge coverage of bonds.

    • fulltimefinance@fulltimefinance.com
      [email protected] March 3, 2017

      It’s a lot of work researching individual bonds. In addition to the health of a company like you would with a stock, you also have a whole separate set of terms to consider.

  2. FTF, I would only buy Treasuries if I was to buy individual bonds – the default risk is too much for a corporate bond for me. In addition, to get a decent return on your cash, as you mentioned above, you’d need to put up a lot of capital.

    I have 20% of my 401k in a bond index fund.

    • fulltimefinance@fulltimefinance.com
      [email protected] March 3, 2017

      Going fully towards funds is probably best for most investors.

  3. MUSTARD SEED MONEY
    MUSTARD SEED MONEY March 4, 2017

    I have to admit that I’ve never owned a bond of any sort in my life. I feel like I am still young enough or maybe naive to believe that equities are the right mix for me. I am also terrified when interest rates start to creep up that those holding bonds might get whacked and we’ll start to hear of some problems with retirees holding bonds. But I could be really wrong since people have talked about the demise of bonds for as long as I can remember.

    • fulltimefinance@fulltimefinance.com
      [email protected] March 4, 2017

      There are a lot of parallels here to my previous post about stock market valuations. The important thing to remember is interest rates do impact bonds, but inflation would have to be massive to drive bonds in the way a stock market crash would. You can also largely offset that risk by matching the term of a liability like a mortgage since debts hedge inflation.

  4. Mrs. BITA
    Mrs. BITA March 5, 2017

    Bond funds all the way for the BITA household. I’ve been looking at munis recently though, and I _might_ go the individual bond route, but the jury is still out.

    • fulltimefinance@fulltimefinance.com
      [email protected] March 5, 2017

      Munis have a lot of tax advantages if your state has solid AAA rated offerings. Our muni position is maybe a fifth of our bond allocation.

  5. My father only holds individuals bonds, for the reasons you’ve listed above. Another potential drawback to the individual bond route is that many of them are callable-so if you’re getting a good interest rate, the company can call the bond, pay it off, and then turn around and issue new bonds at better rates .With our current record-low rate environment, this probably isn’t as much of a concern as it was in the 1980’s, but it’s definitely a potential drawback.

    I, on the other hand, only hold bond funds because I’m fine with the interest rate risk and prefer simplicity. I do try to spread out bond duration so I have short, mid, and long term bonds to diversify the duration risk.

    • fulltimefinance@fulltimefinance.com
      [email protected] March 5, 2017

      Over the last 4-5 years I’ve had a significant number of bonds called, but you are right. It’s starting to slow down these days as the decrease in rates seems to have subsided. Good call on spreading duration. Which funds are you using?

  6. Secret CFP
    Secret CFP April 11, 2017

    Really?? Bond funds never come due. You can lose you principal. You can’t control tax ramifications (as with all funds really). The coupon is not set or predictable. It’s worth it to me to hold individual bonds, even if it takes a little more effort.

    • fulltimefinance@fulltimefinance.com
      [email protected] April 12, 2017

      I agree with your point about coupons, but taxation is a question of investment account (tax advantaged or not), vehicle (etf or mutual fund), or bond type (muni or corporate). It should not be an individual or bond fund question. As for loss of principal, the difference here is largely an illusion. When you sell a bond at a loss you do so because the interest rates have increased beyond what the bond provides. The price moves inverse the yield. So if you sell the bond and buy another at the new higher rate, due to arbitrage the higher yield must offset the principal loss on the first bond. Thus on aggregate the bond fund should have the same impact to your overall finances as the individual bond over the long haul (bond defaults being the exception). Why? Because this sell and reinvest is all they are doing in the background.

  7. Kevin drevik
    Kevin drevik April 27, 2017

    A couple of years ago I turned past the 50+ year mark, and switched my asset allocation from 20% bonds to 30%.

    I chose to stick with bond index funds (primarly intermediate 7-10 year terms) for that. I don’t think I have enough time to do the individual company research.

    While not a big fan of bonds (especially now that the rates are going up) I recognize the need for them as I get older. Plan is when I get to 60, I’ll go to 40% bonds, and then I’ll probably stick at 60/40 for most of my retirement.

    FYI, I’m about 39 months from financial independence (hence my blog name) so things are going OK

    • fulltimefinance@fulltimefinance.com
      [email protected] April 27, 2017

      Sounds like you have a good plan ahead of you. Any particular index fund you use?

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