Bond Myths Debunked
Clients and prospective clients often ask why we purchase bond funds rather than individual bonds. On the surface, individual bonds provide a sense of stability and control. Because they mature at a stated value, some investors believe they can reduce price fluctuations by holding a bond until maturity to receive a known payout. Others can be reluctant to sell individual bonds with higher interest rates (or coupons), particularly in lower–rate environments.
In practice, both individual bonds and bond funds are influenced by the same underlying forces—changes in interest rates and credit conditions. Understanding bond pricing and the unique advantages of a fund structure are important first steps in deciding whether to invest in individual bonds or bond funds.
Bond Pricing
Like stocks, individual bonds are priced and traded intraday. Market participants price bonds along two primary risk factors—credit risk and interest rate risk. Credit risk is the risk that a bond will default. Bonds with higher credit risk should offer a higher interest payment to compensate for the higher risk. Interest rate risk, measured by a bond’s duration, refers to the inverse relationship between changes in interest rates and bond prices. As interest rates fall, bond prices rise and vice versa. (See our blog post Understanding Bonds and Their Purpose in a Portfolio for a more detailed explanation of how bonds are priced and their role in a portfolio.)
Regardless of when a bond was originally purchased or what interest rate (coupon) it carries, the market continuously reprices it so that its return aligns with prevailing conditions. During lower-interest rate environments, an older, higher-coupon bond may appear more attractive than a newer, lower-coupon bond with similar characteristics. But many investors fail to realize that the older, higher-coupon bond price has appreciated in value to compensate the bondholder should they wish to sell the bond prior to maturity. Mathematically, a higher-coupon bond should be priced such that the bondholder is indifferent between holding the bond to maturity and selling the bond and immediately reinvesting the proceeds in a lower-coupon bond. Therefore, the decision centers on whether to recognize the return in the form of a capital gain today or as ordinary income in the future.
Individual Bond Myths
Just because an investor owns an individual bond and plans to hold it until maturity does not mean that its value doesn’t fluctuate, nor does it mean that value can’t be lost—all bonds move in response to daily changes in interest rates, credit conditions, and a host of other variables. A bond fund with the same duration and credit quality as an individual bond will generally have similar volatility characteristics as the bond itself—the main difference is the concentration risk associated with owning a bond from a single issuer.
We understand the appeal of owning a bond to maturity, since a bondholder knows the value he or she will receive at the end of the period, while a fund owner does not. But the perceived safety is merely a function of ignoring the price fluctuations along the way. Because bond funds don’t have a finite time horizon, more attention is given to the daily pricing of funds than to individual bonds.
The Case for Bond Funds
One of the primary benefits of using funds in lieu of individual bond holdings is the ease and cost with which a fund can be sold or liquidated. With one simple trade, the bond allocation can be adjusted to precision. This is more challenging with a portfolio of individual bonds, as investors are forced to trade in round lots (i.e. 10,000 or 25,000) unique to the bond’s issuance.
Bond funds also benefit from scale. The collective buying power of a fund can provide significant cost advantages over those faced by individual investors. Bid-ask spreads—the difference between the price an investor receives when selling a bond and the price paid to buy it—are a hidden cost of owning individual bonds and often represent a source from which brokerage firms profit at the expense of their retail clients. Experienced bond fund managers can offer significant value simply through the scale with which they operate.
Moreover, bond funds will own hundreds of bonds with different maturities, credit quality, and sectors. This level of diversification is often impossible to achieve with individual bonds. Additionally, interest generated by the bonds in the fund is constantly reinvested, whereas interest generated by individually held bonds must accumulate before reaching a level sufficient for additional bond purchases.
Bonds play an important role in portfolios by providing income, diversification, and stability. Although individual bonds and bond funds are influenced by a similar set of core risk factors, the structure used to access that exposure matters. At Truepoint, we believe the trading efficiency, cost advantages, and diversification offered by bond funds give them a meaningful edge over individual bonds in a well-balanced portfolio.
