Fixed income investments

Bonds versus bond funds

Help clients understand the trade-offs to owning individual bonds versus bond funds

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Overview

Bond funds: A glimpse into the investing strategy

Am I better off with bond funds or a portfolio of individual bonds? Answering this question for clients can inform conversations as you consider the fixed income portion of their investment portfolios.

Bond mutual funds and ETFs are pooled investment vehicles managed by professionals that can give your clients income and portfolio diversification over the long run. A portfolio of individual bonds that you construct on behalf of clients, and where cash flows are being reinvested back into the portfolio, operates in much the same way.

Both strategies can be tailored to meet client-specific goals and objectives. Both also typically pay interest at regular intervals and allow your clients to tailor the portfolio to meet specific financial goals, risk tolerance, and time horizons.

Some key points to consider:

  • Bond funds generally offer greater return opportunities, lower transaction costs, and higher liquidity than comparable portfolios of individual bonds. Diversification among issuers, credit qualities, and maturities is another key advantage.
  • The direct and indirect costs associated with portfolios of individual bonds means holding them can be costlier to many clients than holding low-cost bond funds.
  • Holding an individual bond to maturity offers little to no financial benefit to your clients versus pooled products when cash flows are reinvested, as often occurs in laddered individual bond strategies.¹
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Benefits of bond funds explained

In this one-minute video, Vanguard Investment Advisor Research Specialist Ted Dinucci discusses some potential advantages of bond funds over portfolios of individual bonds.

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Bond ladder pros and cons

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.

Bond fund benefits

Advantages of bond funds

Diversification advantage can mean higher returns

Bond funds can offer more consistent exposure and greater diversification because of the larger pool of investable assets and the continuous investment in new offerings. This can translate into meaningful benefits for clients in terms of returns and protection against default risk. For municipal and corporate bonds in particular, diversification among issuers, credit qualities, and maturities is a primary consideration to help minimize potential exposure to the effects of credit downgrades.

For example, while defaults among high-quality investment grade bonds are relatively rare, a portfolio that consists of only 10 or 20 individual bonds still exposes clients to a greater degree of issuer-specific risk. Compare that to a bond fund with many more holdings and a team of investment professionals who can select securities that best capture the desired exposures.

If one bond experiences a credit downgrade to a specific issuer in a smaller portfolio of individual bonds, it could meaningfully affect that portfolio. The greater diversification possible with bond funds and ETFs means potentially higher returns for your clients with a similar level of risk.

 

Growth of a hypothetical $1 million initial investment from January 1997

A bar chart showing the ending wealth, in U.S. dollars, given separate $1 million investments in two investment-grade corporate bond benchmarks. The left bar is the ending wealth from the $1 million investment in the AA rated corporate bond index and the bar on the right is the ending wealth from the $1 million investment in a broad, investment-grade corporate bond index. The vertical axis shows wealth, in millions of U.S. dollars, and the horizontal axis displays the names for the bars in the figure. Moving from left to right the horizontal axis reads: AA corporates, Broad investment-grade corporates. The takeaway being that, given equal starting investments, the broad investment-grade corporate bond index resulted in greater ending wealth than the AA rated corporate bond index.

 

Notes: Figure assumes a hypothetical initial $1 million investment on January 1, 1997, held until April 30, 2022. AA corporates as represented by ICE BofA 5–10 Year AA US Corporate Index; and broad I-G corporates as represented by ICE BofA 5–10 Year US Corporate Index.

Sources: Vanguard analysis of Morningstar data, as of April 2022.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Bond funds also help clients benefit from the opportunities that a fund manager’s professional staff can bring to the table: risk, trade, and credit analysis. This allows those funds to seek return opportunities farther out on the credit quality spectrum, which can deliver higher returns, as the chart above shows. For example, by expanding the investment opportunity beyond AA-rated corporate bonds into investment-grade corporates, you can drive excess wealth with lower-quality bonds in the portfolio.

Fund managers who are fully focused on credit analysis may also be better suited to spot credit risks sooner, thus avoiding the negative effects of downgrades and defaults.

Lower transaction costs

All bond portfolios incur costs. Costs associated with management often receive the lion’s share of attention, but they’re only part of the equation. Transaction costs, or bid-ask spreads, should also receive scrutiny to ensure they are not detrimental to a client’s long-term financial outcomes. Wider bid-ask spreads can increase trading costs. This is yet another reason that bond funds, with lower trading costs, can be advantageous to your clients.

Bid-ask spreads are typically larger for small transactions, such as those for individual bonds, which can translate to lower returns for your clients. Institutional asset managers, such as Vanguard, which buy and sell large quantities of bonds, can command higher prices for sales and lower prices for buys. This can add up to a transaction cost advantage over individual bond portfolios. The benefits of scale are most significant in the municipal bond market.

Spreads are typically larger for retail trades relative to institutional trades (bps)

A bar chart showing the average effective spread for individual municipal bond transactions of various trade sizes. The bars are organized into transaction size buckets with the far-left bar showing the average effective spread for the smallest municipal bond transactions and the far-right bar showing the average effective spread for the largest municipal bond transactions. Moving from left to right the horizontal axis reads: $10,000 or less, $10,001 to $25,000, $25,001 to $100,000, $100,001 to $1 million, $1 million+. The takeaway is that municipal bond transaction costs are inversely related to the size of transaction; meaning, the smaller the trade size the more customers are likely to pay in transaction costs and vice versa.

Notes: The above figure shows the average effective spread for municipal bond transactions of various sizes from January 2019 to April 2021. Effective spread is a measure of customer transaction costs and is computed daily for each bond as the difference between the volume-weighted average dealer-to-customer buy and sell price, and is then averaged across bonds using equal weighting.

Sources: MSRB data and Vanguard analysis.

Greater liquidity

Larger firms can get the broadest access to bonds in the primary market. Greater liquidity means it’s easier and quicker for your clients to buy and sell the bond fund assets without significantly affecting the asset's price. 

Save time, add more value to your client relationships

Portfolios of individual bonds require additional time on your part to manage. Using bond funds and ETFs for your clients instead can free you to spend more time on client-facing activities such as behavioral coaching and customized wealth management.

Yield-to-Maturity myth

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
 

Coupon (annual interest payment) 6.00% 4.00% $0.02
Market price as a percentage of face value 116.35% 100.00% $0.84
Yield to maturity 4.00% 4.00% 0.04

 

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.

Have questions about fixed income? Contact us.

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Disclosures and footnotes

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

For more information about Vanguard funds, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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.

Municipal bond fund distributions, including any market discount recognized by the Fund's investments, may be taxable as ordinary income or capital gains. A majority of the income dividends that you receive from the Fund are expected to be exempt from federal income taxes. However, a portion of the Fund’s distributions may be subject to federal, state, or local income taxes or the federal alternative minimum tax. You should consult your own tax advisor with respect to any particular U.S. or non-U.S. tax consequences of your investment in the Fund.