“Things are not always as they seem; the first appearance deceives many.” – Phaedrus
“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?
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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.
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).
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.
Read the full article here by Laurence B. Siegel, Advisor Perspectives.
