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THE DILEMMA THAT ISN’T: BONDS VERSUS BOND FUNDS
by Laurence B. Siegel, 3/27/23
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“Things are not always as they seem; the first appearance deceives many.” –
Phaedrus1
“I’m not what I appear to be.” – John Lennon and Paul McCartney
Should investors build their own portfolios of bonds, or buy shares of bond
funds? Is there an economic difference or just one of appearance? Are directly
held bonds safer because they mature, and you get your money back? How should
one decide?
Let’s ask the experts. Their differing views frame the question. Then, I’ll
provide my answer.
“You get your money back”
Many investors and their advisors favor individually assembled portfolios of
bonds, usually “laddered” so that each bond matures at a different time,
providing a predictable stream of cash. Annette Thau, a former municipal bond
trader and author of The Bond Book, expressed the traditional argument in favor
of holding individual bonds:
While you can invest in any sector of the bond market either through a bond fund
or by buying individual bonds, the two are radically different investments.
The main difference is that an individual bond has a definite maturity date, and
a fund does not. If you hold a bond to maturity, on that date it will be
redeemed at par, regardless of the level of interest rates prevailing on the
bond’s maturity date. Assuming a default has not occurred, you get back 100% of
your principal. You have also earned a predictable income for the period that
you have held the bond, consisting of coupon interest and, if coupons were
reinvested, of interest-on-interest.2
I contend – and I have much support from other experts, whom I cite below – that
getting your money back is, in economic terms, exactly like not getting your
money back (and instead selling the bond or bond fund when you want the cash).3
Another related, but distinct, argument favoring the ladder has to do with
volatility. In her balanced, pro-and-con treatment of the issue, Schwab’s Kathy
Jones wrote:
[A] downside to owning bond funds is...[that] the net asset value (NAV) will
fluctuate with the market: As interest rates rise and fall, the NAV of a given
bond fund will fall and rise respectively, and there’s no certainty as to what
the NAV may be at a point in the future. This makes bond funds less attractive
than individual bonds when planning for future liabilities.4
But there is no substance to this argument. The value of your individually
selected bonds rises and falls in the same way that the NAV of a bond fund does.
You may not observe the price variation directly, but that doesn’t mean it’s not
happening. More on that below.
Real versus nominal
When you do get your money back at the time a bond matures, you only get it back
in nominal terms. The real, or inflation-adjusted, value of the money you get
back is not knowable until the moment you get it. Thus, the apparent safety in a
bond maturing and returning your original investment is an illusion, because
only real returns matter. Ben Carlson, author of the delightful Wealth of Common
Sense blog,5 expresses this concept pithily:
“Getting your money back” at maturity might be a wonderful emotional hedge but
it’s not like you’re any better or worse off. When rates go up, the value of all
bonds goes down, whether you’re holding an individual bond or a bond fund.
While holding to maturity does allow you to get your principal value back at
par, in an environment of higher rates and inflation you will still be getting
back nominal dollars that are worth less at the time of maturity [than they were
when you bought the bond].
For example, let’s say you own a bond fund that yields 2% and rates [then] go to
4%. If the duration of those bonds is 5 years, you would expect that fund to
fall something like 10% in value.... [L]et’s [now] say you then decided to sell
your bond fund but then buy all of the individual bonds in that fund which now
collectively yield 4% and hold them to maturity.
Are you better off now or not? No – you’re in the exact same place either way!
The reason, which Carlson didn’t need to state because it was too obvious, is
that the bonds you’re buying have gone down by exactly as much as the bonds
you’re selling. The value of a package of securities (bonds or anything else) is
the same whether or not you open the package and see what’s inside.
On the other hand...
Transaction costs can be minimal for a self-managed bond portfolio.
Some of the advantages of managing your own bond portfolio are real. One is that
transaction costs, as measured, can be managed to exactly zero by buying only
U.S. Treasury bonds – directly from the Treasury when originally issued (that
is, not in the secondary market) – and holding them to maturity. I emphasize “as
measured” because nobody works for free, so the Treasury’s cost of distributing
bonds to the public is paid somewhere along the line. This cost should,
logically, be impounded in the bond’s yield, which would be slightly higher if
there were no such cost.
This cost savings, if it exists, applies only to Treasury bonds. Higher-yielding
corporates and tax-exempt municipal bonds must be bought from a broker-dealer.
(A few municipal issues can be bought directly from the issuer, avoiding
transaction costs.) This is an important consideration because a Treasury-only
portfolio isn’t right for everybody.
Manager fees and expenses
Second, and important for any investor, is the matter of manager fees and
expenses. Bond portfolio managers don’t work for free – their paychecks can be
quite generous – and they have high-priced expenses such as data feeds, office
space, and the legal and administrative costs of setting up a fund. All these
costs are reflected in fund expense ratios that range broadly. Individuals
building their own bond portfolios don’t pay those fees or expenses, other than
the value of their own time and effort; this can represent a considerable cost
savings, especially relative to a high-expense-ratio fund or ETF. Fund fees and
expenses are cumulative and add up over long time periods.
Index funds and passive ETFs are, of course, the cheapest options: Vanguard’s
intermediate-term Treasury bond index fund has a rock-bottom expense ratio of
0.07%, or $700 per year per million dollars invested.6 Adding non-Treasury bonds
increases the expense ratio, as does active management. The large, actively
managed total-return bond funds, which include many types of bonds, not just
Treasury securities, have expense ratios of 0.40% to 0.50%, so there is a bigger
hurdle to produce alpha (outperform an index fund).
Bond index funds and index ETFs with expense ratios of 0.10% or lower are so
economical that it’s hard for advisors to save money with a do-it-yourself
approach (unless the advisor has a very large account). Do-it-yourself costs are
largely independent of account size, so costs loom larger as a percentage of
asset value for smaller accounts, tipping the balance for such accounts in favor
of a bond fund.
A third, very minor advantage to a self-managed portfolio is that you can
express your tastes and preferences, for example regarding ESG criteria, by
buying or avoiding specific bonds. A bond fund manager is selecting the bonds
that he or she thinks will please their customer base, not you alone.
Moreover, diversification in the bond market isn’t as beneficial as in the stock
market. Most bonds of similar duration and credit quality move together. For
this reason, a portfolio of just a few bonds can capture most of the return
available in the bond market. This isn’t exactly an advantage of buying bonds
individually, but it puts that strategy at less of a disadvantage than if you
needed a large bond portfolio to achieve diversification.
Finally, there is some psychological benefit to knowing exactly when the cash
will come in and how much it will be (in nominal terms of course). It’s
important to know that, if you do this, you haven’t reduced or eliminated
inflation risk, which is the most important risk when holding a bond portfolio.
Vanguard’s perspective
A detailed Vanguard report7 comparing individually held bonds with bond funds
began by making the same getting-your-money-back, diversification, and
transaction-cost arguments as those I made above. It summarized by noting the
following advantages for each strategy:
What’s the advantage of control if you have to sacrifice diversification,
“return opportunities” (Vanguard’s claim of being able to add alpha or to buy
bonds that most individuals cannot), and transaction-cost efficiency to get it?
The Vanguard authors don’t find that control gives much benefit in bond
selection or asset-liability cash-flow matching, but they make some valid points
regarding taxes:
Because clients directly own the bonds in... a laddered bond portfolio, as their
advisor you can use any net losses from individual bond positions for tax
purposes to partially offset your client’s earned income or to offset realized
capital gain liabilities from other investments.
You can’t do that with a mutual fund or ETF. However, Vanguard points out that:
[a] fund uses realized losses against realized gains and carries forward any
excess losses to be used against future gains. Although this may defer the
pass-through of losses, it provides long-term tax efficiency to the pooled
structure. In addition, as the advisor, you have a further option: You can sell
your clients’ fund shares to realize a loss where applicable.
Control doesn’t turn out to be much of a win from that perspective.
But there’s a subtle advantage to individually held bonds that applies to
investors who are subject to the alternative minimum tax, or AMT: “the portfolio
can be tailored to bonds that are exempt from AMT, or specific to issues from
your client’s home state.” More importantly, the realization of capital gains
and losses on individual bonds can be timed by the advisor to reduce AMT
liability.8
What would Cliff Asness do?
When I can’t quite find the right words to express a concept in investment
management, I often turn to Cliff Asness, who has a gift of gab (sometimes
acerbic) that is unmatched in our business. In his award-winning Financial
Analysts Journal article, “My Top Ten Peeves,” Asness admitted that the
perception of bonds being safer than bond funds “may even be helpful to
investors” – but it is a misperception nonetheless. His star power was evidenced
by the FAJ giving Asness one of its top awards for a list of “peeves” rather
than for the quantitative research that the magazine is known for. He writes:
Bond funds are just portfolios of bonds marked to market every day. How can they
be worse than the sum of what they own?
They could be. Structure matters. An ETF is better for most taxable investors
than a 1940 Act mutual fund. Individual bonds can help with the tax problems
noted above. But, in the general case, the bond fund is not worse than the sum
of the bonds it owns. It’s not better. It’s the same.
Asness next repeated some of the arguments I made earlier, on which Carlson and
the Vanguard authors elaborated. He then brought up a new angle:
Those believing in the fallacy [of individual-bond superiority] often also
assert that another negative feature of bond funds is that “they never mature”
whereas individual bonds do. That’s true. I’m not sure why anyone would care,
but it’s true. But the real irony is that it’s only true for individual bonds,
not the actual individual bond portfolio these same investors usually own.
Investors in individual bonds typically reinvest the proceeds of maturing bonds
in new long-term bonds... In other words, their portfolio of individual bonds,
each of which individually has the wonderful property of eventually maturing,
never itself matures. Again, this is precisely like the bond funds that they
believe they must avoid at all costs.
Getting your money back is exactly like not getting your money back.
How, then, might the misperception of individual-bond superiority be helpful to
investors, despite its illogic? “It’s possible,” Asness wrote, “that the false
belief that individual bonds don’t change in price each day like a bond fund…
[leads] to better, more patient investor behavior.” In other words, waiting for
a bond to mature may have the unintended side effect of getting you not to
trade, while an investor observing the vagaries of a bond fund’s NAV might trade
more often. Not trading beats trading, and patience is a virtue.
Conclusion: Bond funds usually win
Returning to the epigraph – appearances can differ greatly from reality – a bond
fund looks quite unlike a bond. A bond fund is a perpetual investment, like a
stock fund, from which the investor can only exit at whatever the market price
is at the time. The cash flows in and out of the fund are affected by the whims
of the other fund shareholders.
A bond, in contrast, is a time-limited investment with a schedule of cash flows
that are guaranteed by the balance sheet of the issuer. There are no interim
cash flows triggered by other people. These two investments, a bond fund and a
bond, then, are obviously quite different.
But that is the wrong comparison! Nobody holds a single bond – at least I hope
they wouldn’t. Individual investors who hold a homemade, laddered portfolio of
bonds are simply managing a one-customer bond fund. They are doing what
professional bond portfolio managers do:
* selecting the bonds based on their duration, credit quality, and other
characteristics;
* laddering them to provide the desired cash flow pattern;
* reinvesting coupons and principal repayment into new bonds, or into
additional holdings of bonds that are already in the portfolio;
* investing new money (cash inflows) into the bond market; and
* paying out cash as desired by the asset owner.
That’s a lot of work, as any bond portfolio manager will tell you. Many
individual investors have simplified the job somewhat – typically by buying only
Treasury issues and limiting themselves to the lower but safer yields that come
from a government guarantee – but they are still doing the bond portfolio
manager’s job themselves. Whether that is an efficient use of their time and
talent, relative to the cost of a commercially available bond fund, is for the
investor to decide. The investor must also decide who is likely to do a better
job, the amateur or the professional.
For most investors under most circumstances, the professional wins.
Laurence B. Siegel is the Gary P. Brinson Director of Research at the CFA
Institute Research Foundation, the author of Fewer, Richer, Greener: Prospects
for Humanity in an Age of Abundance, and an independent consultant. His latest
book, Unknown Knowns: On Economics, Investing, Progress, and Folly, contains
many articles previously published in Advisor Perspectives. He may be reached at
lbsiegel@uchicago.edu. His website is http://www.larrysiegel.org.
1Phaedrus is a character in Plato’s book Phaedrus, and is based on a real person
of the same name with whom Plato engaged.
2Quoted at https://www.bogleheads.org/wiki/Individual_bonds_vs_a_bond_fund. The
original source is Thau, Annette. 2011. The Bond Book, Third Edition, New York:
McGraw-Hill.
3I’m indebted to that gifted satirist and smartass, the late P. J. O’Rourke, for
this expression – but he was talking about the Social Security trust fund:
“Having a Social Security trust fund is exactly like not having a Social
Security trust fund,” his summary, in a speech, of the argument he made in
Parliament of Whores, 2003, pp. 211-220. (I’m quoting from memory; I heard the
speech at the Heartland Institute, September 15, 2016.)
4https://www.schwab.com/learn/story/bonds-vs-bond-funds-which-is-right-you
5https://awealthofcommonsense.com/2022/11/owning-individual-bonds-vs-owning-a-bond-fund/
6This is for the Admiral class of shares, which has a $50,000 minimum
investment. The Investor class, with a much lower minimum, has a 0.20% expense
ratio.
7Dinucci, Ted, Chris Tidmore, and Chris Pettit. 2022. “Individual bonds versus
bond funds: Our thoughts on the advisory practice and client outcomes.” Vanguard
Investment Advisory Research Center (October),
https://advisors.vanguard.com/iwe/pdf/FAIBVBF.pdf
8The AMT advantage accruing to individually held bonds applies only to taxable
investments, not to bonds or bond funds held in a tax-deferred (IRA or 401k) or
tax-exempt (Roth IRA) accounts.
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