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?