Which is better—owning bonds directly or buying a low-cost highly diversified bond fund?
Though the answer for most people is through the ETF, there are a couple of exceptions. I’m going to start with a little myth-busting, and then describe when the funds are typically superior and when certain bonds may be better.
The Biggest Myth of Owning Bonds
This is the myth I’ve heard countless times—if you buy the individual bond and hold to maturity, you don’t have any interest rate risk. It’s completely false and here’s why.
Last year was the worst in the history of the bond market. Two of the largest bond ETFs, Vanguard Total Bond Market ETF (BND) and iShares Core U.S. Aggregate Bond ETF (AGG), lost 13.11% and 13.02%, respectively, including the dividends being reinvested.
Now compare that to buying an individual bond of even a slightly lower duration—a 7-Year US Treasury note which was yielding 1.55% as of the first trading day of 2022. Someone who bought that will get their money back but that doesn’t mean they didn’t have a loss.
Fast forward one year later, and a 7-year Treasury was yielding 3.89% which is an extra 2.34 percentage points annually for the remaining six years. That opportunity cost of earning a below market rate is essentially the equivalent of the loss on either of those two bond ETFs. In fact, the brokerage statement would show such a loss. Admittedly, it’s easier for the investor to convince himself he has had no loss but this is a fantasy.
Three Reasons Funds are Generally Better
- Diversification
Owning a couple dozen municipal or corporate bonds might seem diversified, but not so much if one or two of the issuers files for bankruptcy. If a client can buy only a few bonds, that is really taking on uncompensated risk. Remember that the Bloomberg Aggregate Bond Index was once called the Lehman Brothers aggregate bond index. This reason isn’t important for US Treasurys assuming we don’t have more than a short-term technical default. More on Treasury’s in a bit.
- Liquidity
Bonds can have large bid-ask spreads to sell certain bonds, such as munis. I typically see spreads of 1% to 3% and, in one case, just over 10%. Corporate bonds also have bid-ask spreads. Large bond funds have access to bigger trades with much smaller spreads. I still see articles favoring bonds only mentioning small commissions but ignore the huge costs of the bid ask spreads.
- Reinvestment of interest
Most bonds have interest or “coupon” payments that aren’t typically reinvested. The cash generally goes into the brokerage default cash account such as Schwab’s yielding only 0.45% annually. Bond funds, on the other hand, give the investor the option of having their payments go back into buying more of the fund, where the money usually earns far more than a brokerage account’s default option. Some brokerage default accounts such as Vanguard’s Federal Money Market (VMFXX) account can actually pay more but this is likely temporary and probably will change.
When To Skip the Funds
As mentioned, we hope Treasury bonds have no default risk and they typically have high liquidity with small bond-ask spreads. They also happen to be fully state and local tax-exempt whereas a fund may only be partially exempt. As shown earlier, it doesn’t reduce interest rate risk but does avoid fees.
These nominal Treasury notes, bonds, or bills are especially good when one has a liability that will be due in nominal terms. A couple of examples would be a known tax liability or an adjustable-rate mortgage where the rate will reset on a certain date. Having an individual Treasury that matures just before the dates the taxes are due or the rate resets provides certainty a bond fund can’t.
Another area where individual bonds are superior can be in Treasury Inflation Protected Securities (TIPS). TIPS pay a real yield above inflation so can be useful if one wants to lock in a certain amount of spending power. TIPS yielded inflation minus 1% in early 2022 but now yield inflation plus about 2.4% annually.
I’ve written about two TIPS strategies earlier this year that can’t generally be done with TIPS funds. The first is to build a TIPS ladder. As of November 15, 2023, a 30-year TIPS ladder could lock in a 4.6% safe spend rate, adjusted for inflation each year. One could also put about 85% in the TIPS ladder to match the 4% safe spend rate and the rest in a low-cost diversified stock index fund for growth.
The second strategy I wrote about is to essentially use a single-issue TIPS along with a stock index fund to guarantee to beat inflation while getting a good part of the return on stocks. I call this the build a better annuity strategy since fixed indexed annuities (FIAs) have very high fees and only promise return of your money in nominal terms which could lose out badly to inflation.
ETFs like the iShares TIPS Bond ETF (TIP) can’t guarantee a certain real return like buying the individual TIPS and holding to maturity. The one exception is the new BlackRock Defined Maturity ETFs and those only go out ten years.
Conclusion
In general, a diversified low-cost and high-quality bond fund beats owning individual bonds. But keep fees below 0.10% and at least half of the total bond portfolio should be backed by the U.S. government. The diversification, liquidity, automatic reinvestments and professional management are worth those small fees and avoid higher hidden fees of buying bonds directly. There is no way that a fund with laddered bonds could have more interest rate risk than if you owned those same bonds directly.
But it’s okay to buy bonds that are backed by the U.S. government. And it’s better than okay if you want to lock in a nominal yield to match a nominal liability or lock in a real return above inflation by buying TIPS and holding to maturity.
