The market has been predicting the Federal Reserve will raise interest rates “soon.” So what will happen if and when they do? Interest rates and bond prices always move in opposite directions. If interest rates go up, the market value of existing bonds will go down.
Given this, some argue that it is better to own individual bonds
that can be held to maturity rather than bond mutual funds which never mature. Individual bonds will receive their full face value at maturity which would avoid this loss, right?
This so-called advantage of bonds versus bond funds is a common misconception. As it turns out, the outcomes are generally very similar whether you hold bonds individually or in a mutual fund. An example of “bond math” illustrates this.
Let’s say the current interest rate for a one year bond is 2%. If you purchased a $1,000 bond at face value you would expect to receive $1,000 one year from now, plus two semi-annual interest payments of $10 each. The market value of that bond is $1,000. This is the equivalent of $1,020/1.02—the total amount you receive as the investor, divided by one plus the interest rate.
Suppose immediately after purchasing this bond, the Federal Reserve increases interest rates such that one year bonds now yield 3%. The market value of your “old” bond will immediately drop to $990.29. This reduction in price is needed to give a new purchaser of your bond a 3% yield (at maturity, the $20 interest payment and $9.71 "discount” combine to give the buyer a 3% yield). But if you if will still receive the full $1,020 at maturity that you expected when you purchased the bond all is well ... right? Not necessarily.
If interest rates increase, the value of a bond mutual fund will drop (reflecting the drop in value of the bonds it holds). But from that point forward, the fund will be priced to receive the current market rate of interest—in our example, 3%. And, as bonds mature, new 3% bonds will be purchased with the proceeds. This will further enhance the fund’s yield. With an individual bond, the income you earn over the bond’s life will be locked in. In this case, you will earn 2% instead of 3%. In real terms, your loss is $10/1.03=$9.71.
A bond fund must recognize losses associated with rising interest rates immediately. Conversely, if held to maturity, the loss associated with an individual bond occurs over the life of the bond (due to the below market rate of interest that the bond will pay). The results, however, are essentially the same.
Given that the financial consequences of rising rates are so similar, we strongly prefer using funds over individual bonds for the following reasons:
- Diversification. Funds hold hundreds of different bonds, minimizing the impact of an individual bond issuer default. For example, the Vanguard California Intermediate Term Tax Exempt Bond fund holds 1,798 bonds. If any one of those were to default the impact on the value of the fund would be insignificant. Compare that to an individual bond portfolio of say, 20 different bonds. If one of those bondsdefaults, you could be risking up to 5% of your bond portfolio. Do you recall what happened with Orange County bonds when they defaulted?
- Cost. Buying and selling individual bonds incurs a hidden cost referred to as the “bid/ask spread.” This is the difference between the price you pay for a bond and what you would receive if you immediately sold the bond right after its purchase. Typically, the smaller the trade, the larger the spread.
Most individual investors trade in “odd lot” sizes below $100,000. Studies have shown the average bid/ask spread for odd lot trades of municipal bonds is around 1.6% of the face value of the bond. Compare that to mutual fund spreads on trades over $1 million which are closer to 0.2%.
Yes, mutual funds do charge an ongoing management fee, but if you use low cost, institutional funds like we do, the cost is minimal compared to the bid/ask spread. For example, the Vanguard CA fund referred to above charges 0.12% per year which is well worth it for the diversification benefits and lower spread costs.
- Convenience. Funds are far easier to buy and sell than individual bonds. This is especially true for small dollar (or “odd lot”) purchases. Smaller purchase or sale amounts are often necessary when funds are deposited or withdrawals are needed.