Bonds versus bond funds

Individual bonds

Portfolios of individual bonds are often constructed to produce reliable income streams for clients as part of an advisor’s financial planning process. These portfolios enable advisors to target specific maturities to deliver targeted income on a desired date. For advisors who prefer to fully manage client bond portfolios, this approach is valued for enabling a degree of control over the holdings.

But individual bonds can have an opportunity cost.

Portfolios of individual bonds with varying maturities, also known as bond ladders, often must focus on higher credit-quality securities than bond funds, resulting in reduced diversification. Bond funds, on the other hand, often maintain greater scale and professional investment teams to invest across a broader spectrum of credit qualities, which can help generate additional wealth from higher-yield opportunities. Clients with laddered bond strategies may be foregoing the potential extra returns of bond funds.

In addition to potential forgone returns from maintaining a higher-credit quality bias, portfolios of individual bonds can be less cost-efficient than bond funds in other ways—for instance, trading costs. Bigger, more established fund managers who purchase large quantities of bonds can potentially get better access to bond issuance and can command better prices than if those bonds were purchased in smaller quantities, as is often the case with individual bond portfolios.

Lastly, the implementation and maintenance of portfolios of individual bonds can be time-consuming and costly, too, leaving you less time to focus on client-facing activities.

The "principal at maturity” myth

During periods of rising interest rates, you may often hear clients ask if it’s better to be invested in individual bonds than in funds. They may believe that keeping individual bonds until maturity means sidestepping market losses from selling bonds as rates are rising. Vanguard has found this so-called “principal at maturity” myth to be exactly that—a myth.

Holding an individual bond to maturity primarily provides an emotional rather than economic benefit. But when the principal paid at maturity is reinvested—as is often the case in bond ladders—the resulting portfolio is similar to a mutual fund but with less diversification and likely higher costs.

This dispels the myth that holding an individual bond to maturity will provide an economic advantage to the investor.

Bond prices, to be competitive, adjust to changing interest rates so that total returns will be equal from that point forward. This happens regardless of whether the bond is held to maturity or sold at the prevailing market price with the proceeds reinvested (absent transaction costs).

The chart below offers a closer look at how this plays out. If 10-year bonds are yielding 4%, the price of a 2% coupon bond adjusts downward to a level that matches the 4% yield-to-maturity of that 10-year bond. The 2% bond would provide the same return as the 4% coupon bond trading at face value, but some of the return would come from the bond’s appreciation from $836.50 to its $1,000 value at maturity, as opposed to the coupon payments.

The price adjustment punctures the myth.

How bond prices adjust to keep yields-to-maturity the same

A comparison of hypothetical bonds with 10 years to maturity
 

Source: Vanguard

Notes: This hypothetical illustration does not represent any particular investment and the rate is not guaranteed.

The yield-to-maturity measures the total rate of return—including the bond’s fluctuating changes in value—that's been earned after a bond has made all interest payments and repaid the original principal.