Why We Use Bond Funds

When we’re talking to clients about bonds, we’ll often hear something like: “Bond funds go up and down like the stock market. It is safer to own individual bonds, because if you hold them maturity, you get your principal back and don’t take any losses.”

In this week’s note, we want to link you to three articles that explain why, in most cases, we believe bond funds are the better option.

The Case for Bond Funds
In 2014, Cliff Asness wrote an article for the Financial Analysts Journal detailing his top ten pet peeves about the investment industry. Number ten was the fallacy that owning individual bonds is somehow better than investing in a bond fund:

“Bond funds are just portfolios of bonds marked to market every day. How can they be worse than the sum of what they own? The option to hold a bond to maturity and “get your money back” (let’s assume no default risk, you know, like we used to assume for US government bonds) is, apparently, greatly valued by many but is in reality valueless. The day interest rates go up, individual bonds fall in value just like the bond fund. By holding the bonds to maturity, you will indeed get your principal back, but in an environment with higher interest rates and inflation, those same nominal dollars will be worth less. The excitement about getting your nominal dollars back eludes me.

But getting your dollars back at maturity isn’t even the real issue. Individual bond prices are published in the same newspapers that publish bond fund prices, although many don’t seem to know that. If you own the bond fund that fell in value, you can sell it right after the fall and still buy the portfolio of individual bonds some say you should have owned to begin with (which, again, also fell in value!). Then, if you really want, you can still hold these individual bonds to maturity and get your irrelevant nominal dollars back. It’s just the same thing.”

The part about bonds starts on page 8 of the pdf, and it is worth a read.

Next, if you are looking for some further reading on the topic, in 2015, Ben Carlson wrote a blog post, Misconceptions About Individual Bonds vs. Bond Funds, where he adds sections explaining why the perceived benefits of individual bonds are generally just mental accounting tricks that add cost and complexity while limiting diversification.

If you are looking for a more analytical review of the topic, this 2022 white paper from Vanguard is very good.

When Should You Own Individual Bonds?
While bond funds make sense for most fixed income investors, individual bonds are the way to go if you know you need a specific amount of money, on a specific date. For example, if you have a wedding coming up in a year, buying a 1-year CD to cover the expense is a terrific idea.

However, for most of the situations we run into helping investors manage wealth in retirement – where the investor plans on reinvesting the principal into new bonds when the previous ones mature – it is our belief that bond funds are the better option.

Background: We Started Out as Bond People
When Crystal, Austin and I got started in the business, it was with Tri-Star Financial, a fixed income broker dealer that specialized in mortgage backed derivatives. The firm also had traders for munis, CDs, and corporates but most of clients were interested in a special type of agency collateralized mortgage obligation (CMO) called an “inverse floater” issued by Fannie Mae, Freddie Mac, or Ginnie Mae.

These mortgage backed derivatives were generally support tranches, inversely leveraged to 1-month LIBOR, with coupons that could range from 0 – 120%, average lives that could range anywhere from a few months to a few decades, and principal windows that could often extend 20+ years. These were risky securities. Our job was to look at the data and find bonds that we believed were uniquely attractive. We then helped clients build concentrated portfolios of these very specific investments. There were no bond funds replicating this strategy so bond funds were never an option.

Fast Forward to Today
The interest rate landscape, the bond market, the fund options, and our risk management strategies have all fundamentally changed over the last 14 years which is why bond funds, rather than individual bonds, are the primary tool we now use for building client fixed income portfolios.

As always, if you have questions about this or anything else, please feel free to schedule some time.