How the "principal at maturity myth" could cost you

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How the "principal at maturity myth" could cost you

Whitepaper

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December 7, 2022

Market volatility. Looming recession. Rising interest rates. Given today’s uncertain economic climate, your clients are likely asking whether they’d be better off investing in individual bonds—particularly tax-exempt vehicles like municipal bonds—rather than in pooled products like ETFs and mutual funds. They may believe the “principal at maturity” myth, which holds that bond funds will sell bonds at a loss when rates rise, while portfolios of individual bonds can be held to maturity and avoid losses.

As new research from Vanguard explains, however, holding an individual bond to maturity offers little to no financial benefit to you or your clients versus pooled products when cash flows are reinvested, as often occurs in laddered individual bond strategies.¹

If you’re holding portfolios of individual bonds, expect to pay greater direct and indirect costs for maintaining complete control of your clients’ bond portfolios. For the vast majority of clients, low-cost bond mutual funds and ETFs  have advantages over portfolios of individual bonds, including:

  • Greater diversification. For municipal and corporate bonds in particular, diversification among issuers, credit qualities, and maturities is a primary consideration. For example, a typical bond ladder may consist of between 10 and 20 bonds, whereas, as of September 30, 2022, the number of holdings in our national municipal bond funds ranged from 3,156 (for Vanguard Long-Term Tax-Exempt Fund) to 9,282 (for Vanguard Limited-Term Tax-Exempt Fund). As a result, bond ladders have higher default risk—if one bond goes bad, it could meaningfully affect a portfolio. The greater diversification that’s possible with bond funds and ETFs can mean potentially higher returns for your clients for similar levels of risk.
  • Lower transaction costs. Bid-ask spreads are typically larger for small transactions, such as those for individual bonds. This can translate to lower returns for your clients. Institutional asset managers, such as Vanguard, that buy and sell large quantities of bonds can command higher prices for sales and lower prices for buys. The benefits of scale are most significant in the municipal bond market.
  • Higher liquidity. Large firms are able to get the broadest access to bonds in the primary market. It’s not only about larger trades and lower costs, but also about what bonds a firm gets to purchase. This is especially important because there tends to be a drop-off in liquidity as time passes from issuance.
  • Time savings for your practice. Portfolios of individual bonds require significant time to manage. Using bond funds and ETFs for your clients instead can free you to spend more time on client-facing activities like behavioral coaching and customized wealth management.

Although individual bonds can provide certain advantages over bond funds and ETFs—primarily your control over security-specific decisions—that control comes at a cost. Especially in the case of municipal and corporate bonds, it’s likely that only clients with enough resources to build a portfolio of comparable scale to a mutual fund or ETF can afford to pay the costs for these control advantages.

To construct an individual bond portfolio, you must assign a very high value to the control benefits to justify the higher costs and additional risks involved.

Individual bonds versus bond funds: Our thoughts on the advisory practice and client outcomes

Download the white paper for more details and analysis showing that during periods of market volatility, the vast majority of clients would be better served by low-cost bond funds and ETFs, rather than by portfolios of individual bonds.

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1 Laddering refers to building a portfolio of bonds with a range of maturities.

Notes:

  • All investing is subject to risk, including possible loss of principal. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. Investments in bonds are subject to interest rate, credit, and inflation risk. Although the income from municipal bonds held by a fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
  • We recommend that you consult a tax or financial advisor about your individual situation.
  • Vanguard is investor-owned, meaning the fund shareholders own the funds, which in turn own Vanguard.

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