Author's note: This article was released to CEF/ETF Income Laboratory members on May 5th.
Interest rate movements meant significant losses for most bond funds in 2022. Some investors reacted by constructing their own personal bond portfolios, in an attempt to reduce interest rate risk and further losses. Due to reader interest, I thought to write an article looking at some of the similarities and differences between investing in bond funds and constructing your own personal bond portfolio.
Bonds are bonds, and behave similarly if held by a fund or an individual investor. Their general characteristics, interest rate payments, capital gains, and total returns, would be more or less the same in either scenario. On the other hand, investors holding individual bonds can tailor their holdings and strategies to their specific needs or wants, while this is generally not the case for investors holding bond funds.
The specific investment strategies used by most funds somewhat differ from those used by most individual bond investors. Bond funds are generally always invested in bonds, automatically re-investing any maturing ones, which means investors are always exposed to interest rate risk. Investors holding individual bonds can always choose not to re-invest in any maturing bonds, which allows them to more easily ignore short-term bond price movements by holding until maturity.
Some investors might prefer to construct their own personal bond portfolios over investing in funds, to have greater control and flexibility over their holdings and strategies.
Bond Funds Versus Holding Individual Bonds - Similarities
Bonds are bonds, and have more or less the same characteristics if held by a fund or by an individual. Interest rate payments, capital gains and/or losses, and total returns are effectively the same. Let's go through each of these.
Interest Rate Payments
Bonds make interest rate payments, and said payments are for the same amount and rate for both funds and individuals. Bonds yielding 5.0%, yield 5.0% for both funds and individuals.
There is a small difference in how investors receive these payments, however.
If held by an individual, bond interest is received by the individual immediately.
If held by a fund, bond interest is first received by the fund, and then distributed to individuals as dividends. ETFs are required to do so by law, with extremely few exceptions. A summary of these requirements follows.
Dividend payments are generally made monthly, sometimes quarterly. Funds have some leeway on when these dividend payments are made, so dividend payments might take longer than expected.
Some income investors might prefer to hold bonds themselves, for greater control, and more timely, interest rate payments.
Capital Gains and Losses
Bonds sometimes fluctuate in price, and said fluctuations are the same for bonds held by an individual or a fund. If 10Y treasury prices decline 20%, then 10Y treasuries held by both types of investors should decline by 20%. Same is true for higher prices.
Individual investors might have an easier time ignoring any losses, as the face value of their investment has not changed, but the losses are nonetheless real. Investors in bond funds might have a difficult time ignoring these losses, as their brokerages or investment platform will very clearly, explicitly label them as such. Still, the losses are the same.
Bonds must be repaid, in full, at maturity, regardless of any short-term fluctuation in price. Investors in individual bonds might have an easier time internalizing that this is the case, as they bought the bond, and, presumably, know when it will mature, and how much money they will receive when it does. Investors in bond funds might have a more difficult time doing so, as bonds were bought by fund managers, and investors, presumably, lack in-depth knowledge of these. Still, bonds must always be repaid, in full, at maturity, and that applies to bonds held by individual investors and bond funds equally.
As bond interest rates, share price fluctuations, capital gains, and losses, are the same for both individual investors and bond funds, total returns are the same too. As an example, the total returns from investing in a 10Y treasury should be the same for an individual investor holding said security, versus a bond fund holding the same.
As should be clear from the above, bonds perform more or less the same if held by an individual or a bond fund. There are, however, some practical differences between these. Let's have a look.
Bond Funds versus Holding Individual Bonds - Differences
Level of Portfolio Control
Investors holding individual bonds have complete control over their bond portfolios. Investors decide which bonds to buy, when to sell, and what to do with any interest or capital payments received. Importantly, investors can choose to roll over their bonds at maturity, or not to.
Investors in bond funds have much more limited control over their (underlying) bond portfolios. Investors can choose which bond fund they'll invest in, but the fund's investment managers will ultimately decide which bonds to invest in, and what to do with any excess cash. Index funds have explicit methodologies, so investors have a very good idea of what these funds will be buying, but limited control over the portfolio itself.
Specific Investment Strategies Used
A corollary of the above is that the investment strategies/index methodologies used by most bond funds are very different from those of most investors. As these vary from fund to fund and investor to investor, it is impossible to go through all possible differences, but I think a broad, general overview or comparison is possible.
The average bond fund holds a portfolio of at least hundreds of bonds and automatically re-invests bonds before maturity. There are exceptions, including term funds.
The average bond investor holds a portfolio of a couple of bonds, holds until maturity, and at maturity, decides whether to re-invest or not. Strategies do differ across investors.
There are significant differences between those two strategies.
The average bond fund is always fully invested in bonds, with all the risks that entails. Bond funds will always decline in price when interest rates rise, for instance. The average bond investor holds at least some cash some days (at maturity), which offers some respite from these risks. At the very least, individual bond investors don't have interest rate risk the day their bonds mature.
Investors in individual bonds can easily pivot from bonds to cash, by not re-investing any maturing bonds. Investors in bond funds have a harder time doing so, as bond funds automatically re-invest bonds before maturity. Investors in bond funds looking to cash out of their position must necessarily sell their position at market prices, with all the risks that entails. Investors in individual bonds are never forced into selling at market prices, as they can simply wait until their bonds mature.
The fundamental characteristics of an individual bond investor portfolio will tend to evolve with time. Specifically, interest rate risk or duration will decline as bonds near maturity. As an example, a 10Y treasury bought by an individual investor today will have very little interest rate risk in 9.9 years, as said treasury will have a very short remaining maturity/duration then. This is very different from a bond fund. An investment in a medium-term treasury fund, like the iShares 7-10 Year Treasury Bond ETF (IEF), will have lots of interest rate risk in 9.9 years, as the fund will have replaced close-to-maturing treasuries with a newer one by then.
Bond funds generally roll over their bonds before maturity, which might lead to different returns from holding bonds until maturity. Returns are dependent on too many factors to count, but I have two general comments. Returns are particularly strong when interest rates are declining, as the strategy is, in effect, selling high-price bonds to buy lower-priced ones continuously when this is the case. The same is true when long-term rates are higher than short-term rates, for more or less the same reason. Both of these have generally been true for decades, but neither is true right now.
Bond funds generally have more holdings than the bond portfolios of individual investors. As such, funds are generally more diversified, and so have less risk.
As an aside, lots of investors and analysts claim that there are significant differences between investing in bond funds and investing in individual bonds. In my opinion, most of these differences are simply differences between the strategies employed by funds and individual investors, described above. Individual investors who employed similar strategies to those of most bond funds would see very similar performance, and vice versa. Individual investors rarely employ the exact same strategies as bond funds, however.
Bond Funds Versus Holding Individual Bonds - Advantages and Disadvantages
In my opinion, individual bonds have two important advantages relative to bond funds.
First, individual bonds allow investors to more narrowly tailor their portfolios to their specific needs and views.
Second, and a corollary to the above, individual bonds are not automatically re-invested, allowing investors greater flexibility in their portfolios or investments. Do bear in mind, this is less of an issue for term funds.
In my opinion, bond funds have two important advantages relative to individual bonds.
First is their simplicity. Bond funds automatically re-balance their portfolios, so investors don't have to.
Second is their diversification, which decreases risk and potential losses from any individual default.
Bonds are bonds, and have more or less the same characteristics if held by a fund or by an individual. The strategies employed do differ, with several important implications for investors. Investors might prefer to hold bonds themselves, to more narrowly tailor their portfolios to their specific needs and views.
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Bond Funds Or Individual Bonds: Which Is The Better Investment? ›
A higher predictability of return: Because the holdings in a bond fund change regularly as issues mature or are called in early by the issuer, and proceeds from these activities are used to purchase new bonds, the investment return also varies. A portfolio of individual bonds, however, has fewer turnover events.Is it better to own individual bonds or bond funds? ›
The main difference is that an individual bond has a definite maturity date and a fund does not. If you hold a bond to maturity, on that date it will be redeemed at par, regardless of the level of interest rates prevailing on the bond's maturity date.Is buying an individual bond cheaper than a bond fund? ›
Investing in individual bonds will require a significantly higher initial investment amount compared to bond funds; the higher investment will help ensure a reasonable amount of diversification across different issuers.What type of bond is best to invest in? ›
U.S. government and agency bonds and securities carry the "full faith and credit" guarantee of the U.S. government and are considered one of the safest investments.Are bond funds a good idea now? ›
Traders are now betting that global central bank tightening cycle will end soon, with cuts priced for the federal funds rate in 2023. If this narrative persists, we think yields will return to their recent lows. This means now could be a good time to buy bonds, particularly 2-year DM bonds, in the short to medium term.What happens to bond funds when interest rates rise? ›
While the upward pressure on rates continues to affect bond prices, net new investments in bond funds will steadily lift yields in the portfolio higher as higher-yielding bonds replace lower-yielding bonds in the fund. This means that, over time, the total return of the bond will increase.What are the cons of a bond fund? ›
The disadvantages of bond funds include higher management fees, the uncertainty created with tax bills, and exposure to interest rate changes.Why are bond funds losing money? ›
Key Takeaways. Bonds are often touted as less risky than stocks—and for the most part, they are—but that does not mean you cannot lose money owning bonds. Bond prices decline when interest rates rise, when the issuer experiences a negative credit event, or as market liquidity dries up.When should you buy bond funds? ›
If your objective is to increase total return and "you have some flexibility in either how much you invest or when you can invest, it's better to buy bonds when interest rates are high and peaking." But for long-term bond fund investors, "rising interest rates can actually be a tailwind," Barrickman says.Do bond funds lose value? ›
When interest rates rise, bond values decrease. The impact, however, will vary according to each investor's individual circumstances. Learn more about the impact of rising interest rates for bond investors, as well as other areas of an investor's portfolio, such as stocks and savings.
Which bond gives highest return? ›
High Yield Bond Funds typically give out a higher rate of return since they have a lower credit rating., Issuers will give out a higher rate of interest to compensate for the risk the investors are willing to take.What bonds make you the most money? ›
Corporate bonds are issued by companies, which have great flexibility in how much debt they can issue. Terms for corporate bonds can be anywhere from less than 5 years to more than 10 years. Corporate bonds pay the highest yields because they offer the most risk.Are bonds a good investment in 2023? ›
“It's important to understand that bonds are generally secure, but not necessarily safe.” As a series of interest rate hikes eroded the value of bonds in 2022, it also did 2023 bond investors a couple of favors. For one, bonds are now offering more attractive interest payments to investors.What are the best bonds to buy in 2023? ›
|Bond ETF||30-Day SEC Yield|
|Vanguard Total Bond Market ETF (ticker: BND)||4%|
|iShares Core US Aggregate Bond ETF (AGG)||3.8%|
|US Treasury 2 Year Note ETF (UTWO)||4%|
|iShares U.S. Treasury Bond ETF (GOVT)||3.8%|
The Bloomberg Global Aggregate bond index rose 3.7% in 2023 through Thursday after a 16% decline last year. The S&P U.S. Aggregate Bond Index fell 12% in 2022 and is up 3.1% since.Should you buy bond funds when interest rates are high? ›
Including bonds in your investment mix makes sense even when interest rates may be rising. Bonds' interest component, a key aspect of total return, can help cushion price declines resulting from increasing interest rates.What happens to bonds when stock market crashes? ›
When the bond market crashes, bond prices plummet quickly, just as stock prices fall dramatically during a stock market crash. Bond market crashes are often triggered by rising interest rates. Bonds are loans from investors to the bond issuer in exchange for interest earned.What bonds do well during inflation? ›
Inflation Bonds Offer High Yields, but There Are Drawbacks
Buying inflation bonds, or I Bonds, is an attractive option for investors looking for a direct hedge against inflation. These Treasury bonds earn monthly interest that combines a fixed rate and the rate of inflation, which is adjusted twice a year.
Bonds with a longer maturity are more sensitive to changes in interest rates, and therefore, more affected by inflation. Inflation impacts the real rate of return of fixed-income investments. This decrease in real return makes the bond less attractive to investors, leading to a decrease in bond prices.Why bonds are not a good investment? ›
If an investor wants a steady income stream, a Treasury bond might be a good choice. However, if interest rates are rising, purchasing a bond may not be a good choice since the fixed rate of interest might underperform the market in the future.
What is the safest type of bond fund? ›
1. Savings Bonds. These are the safest investment since they're backed by the government and guaranteed not to lose principal.Why would you invest in a bond fund? ›
Investors buy bonds because: They provide a predictable income stream. Typically, bonds pay interest twice a year. If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while investing.Are bond funds doomed? ›
With the Fed in a rate-hiking mission, bond funds are doomed to continue their money-losing record. This may be hard to accept for some market participants, because they have had a good run with bond for 40 years.What was the worst year for bond funds? ›
According to the Barclay's U.S. Aggregate Bond Index, 2022 was the worst year in since they started recording in 1976 for bonds. Since 1976 in fact, we've only have 5 negative years in the bond market. Last year, 2022, was historically bad – down 13%. Why was it so bad and what does it mean for you?Are bond funds safe in a recession? ›
Bonds and cash have historically outperformed most stocks during recessions. Selling stocks in favor of bonds and cash before a recession may leave you unprepared if stocks bounce back before the economy does, which has happened historically during many recessions.How much should I invest in bonds? ›
The rule stipulates investing 90% of one's investment capital towards low-cost stock-based index funds and the remainder 10% to short-term government bonds.Is it better to invest in stocks or bonds right now? ›
Generally, bonds are best for those that are conservative and nearing retirement age. They provide steady, reliable income and have relatively low levels of risk. If you have more time to reach your goals, investing in the stock market is likely a better option than bonds.How do I choose a bond fund? ›
- How long do you intend to keep the money invested? ...
- Are you investing for current income or for long-term growth? ...
- How comfortable are you with risk?
When people think about investing for the long run, they often look to average market returns. For example, the broad U.S. stock market delivered a 10.0% average annual return over the past 30 years through the end of 2018, while the average annual return for bonds was 6.1%.What is the highest 5 year bond yield? ›
Historically, the 5 Year treasury yield reached as high as 16.27% in 1981, as the Federal Reserve was aggressively raising benchmark rates in an effort to contain inflation.
Do millionaires invest in bonds? ›
According to Vanguard, the asset allocation of a typical millionaire household is: 65% Stocks (Equity) 25% Bonds (Fixed income) 10% Cash.What bonds pay 10%? ›
Series EE Bonds Issued May 2005 and Later
Series EE bonds issued from May 2022 through October 2022 earn today's announced rate of . 10%.
Common types of securities include bonds, stocks and funds (mutual and exchange-traded). Funds and stocks are the bread-and-butter of investment portfolios. Billionaires use these investments to ensure their money grows steadily.
EE Bond and I Bond Differences
The interest rate on EE bonds is fixed for at least the first 20 years, while I bonds offer rates that are adjusted twice a year to protect from inflation. EE bonds offer a guaranteed return that doubles your investment if held for 20 years. There is no guaranteed return with I bonds.
Investors find I bonds attractive because they provide a helpful way for your portfolio to keep up with inflation. Rates on these bonds adjust each November and May. The rate you receive is locked in for six months after the date of your purchase. These bonds come with some key risk protections, too.Can I keep buying I bonds every year? ›
While there's no limit on how often you can buy I bonds, there is a limit on how much a given Social Security number can purchase annually. Here are the annual limits: Up to $10,000 in I bonds annually online. Up to $5,000 in paper I bonds with money from a tax refund.What is the best investment for 2023 recession? ›
- The Best Recession Stocks of May 2023.
- Merck & Company, Inc. ( MRK)
- Becton, Dickinson and Company (BDX)
- CMS Energy Corporation (CMS)
- PepsiCo, Inc. ( PEP)
- Ameren Corporation (AEE)
- Xcel Energy Inc. ( XEL)
- Thermo Fisher Scientific Inc. ( TMO)
Both certificates of deposit (CDs) and bonds are considered safe-haven investments with modest returns and low risk. When interest rates are high, a CD may yield a better return than a bond. When interest rates are low, a bond may be the higher-paying investment.What is the 5 year bond predictions? ›
The United States 5 Year Note Yield is expected to trade at 3.57 percent by the end of this quarter, according to Trading Economics global macro models and analysts expectations. Looking forward, we estimate it to trade at 3.97 in 12 months time. Facebook | Meta Platforms, Inc.Where will the 10 year treasury be in 2023? ›
In April 2023, the yield on a 10 year U.S. Treasury note was 3.46 percent, forecasted to increase to reach 3.48 percent by December 2023. Treasury securities are debt instruments used by the government to finance the national debt. Who owns treasury notes?
How high will the 10 year treasury go in 2023? ›
The United States 10 Years Government Bond Yield is expected to be 4.108% by the end of September 2023. It would mean an increase of 31.3 bp, if compared to last quotation (3.795%, last update 27 May 2023 2:15 GMT+0). Forecasts are calculated with a trend following algorithm.What is the maximum I bond for 2023? ›
A given Social Security Number or Employer Identification Number can buy up to these amounts in savings bonds each calendar year: $10,000 in electronic EE bonds. $10,000 in electronic I bonds. $5,000 in paper I bonds that you can buy when you file federal tax forms.Will CD rates go up in 2023? ›
Yes, CD rates are currently on the rise. In March 2023, the Federal Open Markets Committee (FOMC) raised the target range for the federal funds rate by 0.25%, bringing the benchmark range to 4.75% to 5.00%. Banks generally use the federal funds rate as a guide when setting rates on savings and lending products.How many bonds should I own? ›
The Rule of 110. The rule of 110 is a rule of thumb that says the percentage of your money invested in stocks should be equal to 110 minus your age. If you are 30 years old, the rule of 110 states you should have 80% (110–30) of your money invested in stocks and 20% invested in bonds.Should I own bonds in my portfolio? ›
Bonds are considered a defensive asset class because they are typically less volatile than some other asset classes such as stocks. Many investors include bonds in their portfolio as a source of diversification to help reduce volatility and overall portfolio risk.Are I bonds better than mutual funds? ›
Mutual Funds Vs Bonds.
|Losses||Investors may sometimes suffer losses but it will be minimal.||Investors receive fixed returns without any losses.|
Investors buy bonds because: They provide a predictable income stream. Typically, bonds pay interest twice a year. If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while investing.What should a 70 year old retiree asset allocation be? ›
At age 60–69, consider a moderate portfolio (60% stock, 35% bonds, 5% cash/cash investments); 70–79, moderately conservative (40% stock, 50% bonds, 10% cash/cash investments); 80 and above, conservative (20% stock, 50% bonds, 30% cash/cash investments).Does Warren Buffett invest in bonds? ›
Buffett has said that when it comes to a retirement strategy, he believes in a 90/10 allocation model, in which 90% of one's money is invested in stock-based index funds, while the remaining 10% is invested in less risky investments like short-term government bonds.Can I buy $100000 worth of I bonds? ›
There is no limit on the total amount that any person or entity can own in savings bonds.
What is the outlook for bonds in 2023? ›
The Outlook for Bonds in 2023
One factor in bonds' favor is that bond yields are now at a level that can help retirees seeking income support a 4% retirement withdrawal rate. Beyond this, both individual bonds and bond funds could benefit if interest rates stabilize or decline.
The 60/40 rule, for example, dictates having 60% of your portfolio in stocks and 40% dedicated to bonds. Or you may use the rule of 100 or 120 instead, which advocates subtracting your age from 100 or 120.What is the safest investment with the highest return? ›
High-quality bonds and fixed-indexed annuities are often considered the safest investments with the highest returns. However, there are many different types of bond funds and annuities, each with risks and rewards. For example, government bonds are generally more stable than corporate bonds based on past performance.What is the safest bond to invest in? ›
The safest type of bond is the U.S. Treasury bill, or T-bill. These are ultrashort fixed-income securities issued by the U.S. government with maturities of a year or less. As a result, they carry low interest rates and minimal default risk.Is it a good idea to invest in individual bonds? ›
If you are looking for predictable value and certainty for your financial goals, then individual bonds may be a better fit. Meanwhile, if you are looking for professional management and want greater diversification for your financial goals, then bond funds may be a better fit.Are individual bonds a good investment? ›
With rising rates, individual bonds held to maturity are poised to deliver a much better performance than bond funds held for similar periods. The case for switching out of bond funds and into individual bonds at this time is strong for those who seek effective diversification against equity positions.When should I buy bond funds? ›
When the economy slows, falling inflation increases the purchasing power of future bond payments. Likewise, because a slowing economy reduces stock returns, investors often flock to bonds in such times, driving up prices. There are rare times, like the mid-March sell-off, when bonds can fall when stocks fall.