I generally try to avoid watching CNBC and other 24-hour financial networks. It seems to me that since they’re forced to fill hours of airtime with something, they often air useless, inaccurate information and have uninformed guests. Unfortunately I witnessed a segment the other day that irritated me to the point of actually yelling at the television.
There was a group of multiple “taking heads” (I think 6, plus the host) discussing the looming increase in interest rates. As per the usual banter, there was one guy who thought the Fed was a hero and another who thought they were destroying capitalism. It got to the point where you couldn’t even understand what they were saying. Modern news at its best. They eventually agreed on one thing though, owning individual bonds was far superior to owning bond funds. It is not so much the statement itself, but the arguments they used to justify this statement. Below are the two arguments I hear all the time that make my head spin.
STATEMENT #1 – “If you own a bond fund you will suffer a loss on your principle if interest rates rise, but if you hold individual bonds you can hold the bond to maturity and get your principle back”
I think the biggest disconnect here is that people forget a key point. Bond funds are marked to market every day and it shows up in its NAV (Net Asset Value). Individual bonds are not. Just because you don’t take the time to mark your individual bonds to market every day doesn’t mean they haven’t lost value. If interest rates rise you can see it clearly in the fund’s NAV (it will go down). If you own an individual bond nobody is going to tell you it lost value, but it certainly did. A 10-year Treasury bond will lose the exact same amount in value if interest rates rise as a bond fund made up of Treasury bonds with an average duration of 10 years. How can a group of bonds be worse than the sum of its parts?
It is 100% true that if you hold a bond to maturity you will get your principle back. But who cares? If interest rates and inflation rise, then those nominal dollars you get back are now worth less. You have gained no advantage by holding them to maturity. If you own a bond fund and the NAV drops due to rising rates, future coupon payments can be reinvested in these new higher coupon bonds. In fact, holding a 5-year bond to maturity and holding a bond fund for 5 years that keeps a constant 5-year duration will yield very similar results (this assumes of course the underlying bonds are similar).
STATEMENT #2 – “Individual bonds have an actual maturity date, but bond funds do not”
Again who cares? Besides I doubt anyone would only buy one bond for their whole portfolio. Instead people who prefer individual bonds usually build bond ladders, buying new bonds once their old ones have matured. This group of bonds also does not have a maturity date, so how is it different than a bond fund? It’s not, but somehow the people who say this can’t see it.
There is nothing magical about owning individual bonds that somehow insulates you from the fact that bonds have interest rate risk. The people who say this are, at their best misinformed, and at their worst deliberately misleading people so they can sell them highly marked up individual bonds.
There are some actual reasons to pick between bond funds and individual bonds. The biggest advantage of bond funds is diversification. They own a much larger amount of bonds than most individuals could accumulate on their own. This, of course, comes with a fee. Here are things to consider if you’re facing the choice:
- If you are going to own corporate bonds you cannot beat the diversification that a bond fund offers.
- If you only want to own Treasury bonds it can make sense to hold them as individual bonds since, theoretically, there is no default risk. Owning a higher number of them adds no value. In this case it can make sense to buy and manage the individual bonds yourself and save the management fee. (As an aside I have actually seen funds with a higher expense ratio than even the most optimistic view of its expected return. Investors in these funds are all but guaranteed to lose money).
- Municipal bond investors can go either way depending on their situation. If you cannot find a bond fund that matches your goal of tax-free income in your particular state, it may make sense to build your own individual bond portfolio (Be aware if the fund invests in AMT bonds. Certain municipal bonds get put back into your income during the AMT calculation
On the day I was screaming at the TV I witnessed all the “talking heads” stop arguing with each other just long enough to agree with the two statements above. It was too much for me to bear, and I suddenly transformed into an old man screaming at the TV. Now that you are more informed, hopefully you can keep your cool the next time you hear this malarkey.