We are often asked why we use bond mutual funds rather than individual bonds in our clients’ portfolios. The question is typically posed as “Why would I own a bond fund when I can buy an actual bond, receive regular interest payments and hold the bond to maturity so I don’t have to worry about losing money?” We believe bond mutual funds provide significant benefits that far outweigh the advantages of holding individual bonds.
The Role of Bonds in a Portfolio
Bonds should be viewed primarily as an effective way to protect asset values and reduce portfolio volatility. Depending on a client’s needs, money allocated to bond funds may be earmarked for near-term expenses, protect against a prolonged market downturn and/or dampen portfolio volatility.
Why Not Use Individual Bonds?
One of the big myths about individual bonds is that they don’t lose value and, if you hold them to maturity, you’ll get your money back. While there is emotional appeal to this thinking, it is deeply flawed. Inflation and changes in interest rates can seriously erode the value you receive at maturity.
For example, if you buy a $10,000, 10 year bond with a 3% coupon, you’ll receive $10,000 back in 10 years and $300/yr. The reality is that you don’t know what $10,000 will be worth in 10 years because the future rate of inflation is unknown. If inflation rises over the 10 years, then the purchasing power of the bond will have declined and your original $10,000 simply won’t buy the same goods and services. In effect, you are losing ground gradually to inflation, which is a less visible loss, but a loss nonetheless.
This same bond will fluctuate in value during the 10 years in response to changes in interest rates, the underlying bond’s credit quality and market liquidity. If you need to access the value of the bond before it matures, you’ll be subject to the same forces as you would be in a bond fund.
The Rationale for Bond Funds
How do bond funds change these dynamics? Simply put, they don’t. However, professionally managed bond funds offer benefits that mitigate the negatives of bonds. By using professionally managed bond funds, an investor benefits from:
- Access to a wider universe of bonds. Most diversified bond funds can own bonds of different maturities, credit qualities, and sectors. Fund managers are in a good position to evaluate the merits of one part of the bond market versus another and make smart decisions about the best place to invest.
- Greater diversification. By using bond funds, one can easily gain exposure to various bond sectors, including inflation-protected, global or high yield bonds.
- Greater ability to analyze credit qualities and react as credit worthiness rises and falls.
- Lower transaction costs. Sales of small quantities of individual bonds can be expensive because the price “haircut”, or spread between the bid and ask prices, eats into profits.
- More liquidity and access. One can sell $1,000 of a bond fund but not necessarily a bond.
- Access to more bond strategies. Bond managers have numerous techniques for improving performance. For example, they may use a “barbell” strategy instead of a “bullet” portfolio or bonds with laddered maturities. They can manage the duration of the portfolio to protect against, or benefit from, changes in interest rates.
- Ability to adjust from exempt to taxable bond as your tax bracket changes, and if your state changes.
In sum, bond funds meet various client needs and provide substantial advantages of flexibility, diversification, and professional management compared to owning individual bonds.
If you would like to learn more about HTG’s total return approach to managing portfolios, read our blog “Income-Oriented versus Total-Return”.