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Individual Bonds: Are They Really Better Than Bond Funds?

In constructing our client portfolios, we rely primarily on DFA funds, for both equity and fixed income securities. While most of our clients understand the value of DFA stock funds, we sometimes get requests for individual bonds, in place of bond funds. This is usually based on the fact that individual bonds can be held to maturity if interest rates rise, thereby assuring repayment of the bond’s face value, or principal. While this strategy seems reasonable at first glance, it does not hold up well to closer scrutiny.

Bond prices have an inverse relationship with prevailing interest rates. In other words, rising interest rates cause a decline in the value of your bond holdings, and vice versa. This occurs because rising interest rates give investors the option of buying newly issued bonds with higher yields, making your currently held bonds less valuable in the open market. On the other hand, if interest rates fall, your bonds become more attractive which boosts their market price. With bond funds, this change in value is manifested by fluctuations of the fund’s NAV (or net asset value), which is established at the end of each trading day. Individual bonds are marked to market every day, reflecting the bond’s value in the open market. Rising interest rates will therefore reduce the value of your bond holdings, whether they are in the form of individual bonds or bond funds.

With individual bonds, you have the option of hanging on to them until maturity, at which point the bond principal is repaid in full. This feature might be advantageous if you only planned to buy one bond during your lifetime, however, the benefit dissipates when considered in more practical terms. Individual bond portfolios are typically constructed of a laddered series of bonds that mature at staggered intervals over time, with the proceeds reinvested as each bond matures. While each individual bond repays its principal at maturity, the laddered portfolio of individual bonds never matures, precisely like the bond funds that an investor may be trying to avoid.

Furthermore, in a rising interest rate environment, which generally occurs in the setting of inflation, the nominal dollars you receive when your bond matures are worth less than when the bond was first purchased. In the end, since bond funds are just portfolios of individual bonds, they are no better or worse than the sum of what they own.

For most investors, bond funds offer several important advantages:

  1. Lower investment amounts: Most bond funds allow you to buy shares with as little as a few thousand dollars, whereas, individual bonds are typically sold in much higher denominations.

  2. Diversification: Bond funds typically hold hundreds of individual bonds providing a valuable diversification benefit, while owners of individual bonds face the possibility of significant losses if one of their bond issuers defaults.

  3. Favorable pricing: High volume bond purchasers, such as DFA, can negotiate more favorable pricing on their bonds than most individual bond purchasers.

  4. Flexibility: Most bond funds distribute their interest income as a regular dividend payment that can either be automatically reinvested or paid out as cash. The latter option can be a nice way of providing monthly income to retirees. Most individual bonds provide interest payments every six months without the option for automatic reinvestment.

In summary, the main purported advantage of individual bonds - the option to hold them to maturity -does not confer a significant benefit to most investors, while bond funds have some attractive practical features. Although personal preferences may vary, most individual investors are better off using bond funds for their fixed income investments.

As always, please feel free to contact me with any questions or comments.

Jeffrey J. Brown, MD CFA Principal, Shearwater Capital

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