Bonds: Buy Them Individually or Wrapped in a Fund?

Which should you take home, bonds or bond funds? We incorporate fixed income investments — bonds, bond funds and cash — into our portfolios for their even temperament. While bonds rarely have much bark, huge losses are also more unusual, except for junk bonds.  Also, the total return of bonds tends to smooth out — while it’s rarely a steep upward climb, returns tend to be present and accounted for.

How Bonds and Funds Make Money

Nowadays, bonds don’t come as ornate certificates with coupons attached. You won’t get to sit at a bank or investment house, clip your coupons and collect your money. Like so many other things, it’s now all virtual. A bond is a loan by the investor to a specific government entity or private corporation.

The issuer declares a face value (in $10 or $100, etc. increments), an amount of interest they promise to pay and the term — how long it will be paid. Bonds are rated as to what pedigree the issuer has — in other words, how likely are they to actually be able to meet the terms of the bonds?

In most cases, the longer you’re willing to tie up your money, the higher the interest you should be paid. The lower the quality of the issuer — hence, the more risk you’re taking — the higher the interest rate. So, it’s easy to see why so-called high interest bonds are also known as junk bonds. High interest is a better marketing term.

The classic way to use bonds was to invest enough in them to produce a dependable stream of income and lock it in for a long time, expecting to hold bonds for their entire term. This practice broke down during the 1980s, when short-term money market rates, and inflation, skyrocketed and holders of long-term bonds paying 4% or 5% felt like chumps.

Individual bonds can be bought through a broker or directly from the issuer, especially in the case of U.S. government securities. While there’s no formal bond exchange as for stocks, it’s possible to sell bonds over the counter, usually through a broker.

To simplify, the price paid will depend on how valuable the interest payout has become and how long the bond has yet to run before redemption. If the bond pays higher than current market rates, the purchase price will go up, and vice versa. But you’ll also likely be nicked a fee for the trade and because a buyer has to be found, the transaction may not be instantaneous.

Bond funds will hold a collection of individual bonds. A fund will either be a specific type of bond — long term, corporate, international, mortgage, municipal — or a broad collection to reflect a total bond market index. A bond fund will, however, have two ways of making money: The actual interest paid by each individual bond (the yield) and the perception of the market as to the value of the underlying investments, increasing or decreasing the fund’s share value.

People often look only at the yield and say that bond funds (currently) stink. It’s more important to look at total return. For example, the current yield of the Vanguard Total Bond Market Index (ticker: VBMFX) is only 2.16% as of Dec. 20. But its one-year total return is 8.83%.

Advantages and Disadvantages

As with adopting puppies, the best qualities can also be the worst qualities. You’ll be vacuuming the hair left by that beautiful fluffy ball and that retriever will smell from the oil that protects him in the water. So too, bonds’ advantage and disadvantage is that they lock up rates. Bond funds’ advantage and disadvantage is that they don’t.

Bonds are almost always going to pay less than you could theoretically make on stock purchases or stocks with dividends. But the yield is going to be much more certain and you pay for that lack of risk, as always. It requires courage to lock in a rate and assume it will be a good one for the duration of the bond. If you’re able to lock in a solid rate, and interest rates later plunge, you’ll feel like a genius. For example, I inherited a 30-year bond my father purchased in 1997. It has a coupon rate of 7.8% and is BBB quality. He looks like a genius now, with bond rates so low, but in 1997 the S&P 500 returned 31%.

Bond funds, on the other hand, don’t lock in your yield and if the type of bond is out of favor, share prices may also decline. On the other hand, you’re not nursing a sick puppy when rates go up: The manager will trade for better bonds. The downside here is that the bonds will be sold at a lower price than what was originally paid resulting in a capital loss for investors. This can be prevalent in a rising interest rate environment.
 
Besides somewhat mitigating the impact of interest rates, bond funds can smooth other risks of individual bonds. Many bonds are callable, meaning that if the issuer can borrow money more cheaply than they’re paying the current bondholders, they’ll “call” the bond. They’ll borrow money somewhere else and pay off the current investors early. While you don’t lose money in this instance, you also won’t be getting the income you expected and you won’t be able to find that yield in the then-current market at the same risk level. While a bond fund may also have some portfolio holdings called, the diversity of holdings will lessen the bite.

Similarly, if you hold individual bonds, some of the issuers can experience a downgrade or even go bust, especially with junk bonds. In the latter case, your investment can be worthless. (My dad had a few of those, too.) It’s hard to hold enough bonds to shrug off such an event. In a fund the downturn will be averaged by the diversity of the portfolio. One disaster will be cushioned by the performance of the rest of the litter.

Which to Adopt

It’s important to think through your needs and what each choice offers. You’re choosing bonds for safety and predictable income.

Historically, bonds have returned 4-5% annually. As the saying goes, times change and with them their possibilities. If rates on individual bonds rise to their historical averages or better, that might be the opportune time to lock in the rates by purchasing individual bonds for your portfolio allocation.

Nothing offers diversity like a mutual fund. You’d have to be very wealthy indeed to approach a reasonable fraction of the more than 17,000 holdings of the Vanguard Total Bond fund.

Bond funds allow you to invest in or emphasize types of bonds that are somewhat non-correlated. Choosing to invest internationally incorporates currency risk, but you can leave those decisions to the bond manager. Similarly, you can choose Treasury Inflation Protected Securities (TIPS) or mortgage-backed bonds, or “high-yield” bonds without the risks of adopting only a few. On the other hand, a broadly diversified bond fund may be enough to incorporate all the different advantages of the various breeds.

One warning: From time to time some star manager “bond king” produces usually temporary grand champion returns for the breed by exploiting arbitrage and high-risk bets. Since most of us find the vagaries of the bond market even more difficult to suss out than stocks, people stampede into those funds.

As with most sudden performance in active funds, by the time the fund produces its wins, the share price already reflects the profit potential. If you’re considering such an actively managed fund, be sure to compare it with what similarly risky investments are doing. With this type of fund, you’ve moved away from incorporating safety into your portfolio in favor of a more speculative play. And you need to keep a close eye that the manager doesn’t escape the yard.

If you ever need the money back, either for use or for rebalancing, it’s much simpler to buy and sell shares of a bond fund than to unload an individual bond. If your heirs inherit your bonds in an individual retirement account, taking the precise required minimum distribution can mean withdrawing or cashing in the whole bond, rather than simply the correct amount of fund shares, which may incur far higher taxes.

There are always a lot of investments barking for your attention. Fixed income is usually the least exciting part of your portfolio, but it’s the part that, like a good watchdog, secures the perimeter and prevents too dangerous incursions into your investment plan.