Investing in Bonds…Funds or Individual Securities? (S3 E4)

Transcript

When it comes to investing in bonds, I’ve met a lot of people over the years who are adamant that buying individual bonds is always better than buying bond mutual funds or ETFs. Their conviction around this belief starts and ends with the same argument every time. They will tell you that as long as you hold a bond to maturity, you cannot lose money, assuming the company doesn’t go bust of course. While this is 100% true and a valid reason to purchase individual bonds, this thinking is extremely shortsighted and ignores the many benefits of bond mutual funds and ETFs that most investors are completely unaware of.

Welcome to the third season of Invested Poorly: Sad Tales of FInancial Fails, now part of the Bold Departure Network. Invested Poorly is a short-form podcast designed to help everyday investors make wiser investment decisions by learning what NOT to do with their money. Host Jeff Harrell shares timeless stories from his former life as a financial advisor, about the poor—and irrational—choices he witnessed investors make that disrupted their journey to financial independence, or FI. Your ability to recognize, and avoid, similar mistakes could make all the difference for you along your path to reach FI.

Check out the “Introduction” episode for more background on Jeff, why he created this podcast, and how it can guide you to becoming the hero of your own investing story. Now, on with the show.

Before we jump into the bond discussion, let’s first make sure we are clear on something. The purpose of bonds in most portfolios is not to generate income, but instead to counterbalance a portfolio and theoretically reduce large drawdowns. There is no doubt about it, a lot of investors can’t stomach watching their net worth drop by 10% or 20% or even more if the stock market enters a bear market. When this happens—and I saw it all the time—you will see investors run for the exits and start selling anything and everything to stop the bleeding.

So the theory is, if you have some bonds in your portfolio, you won’t see as large of a drop when this occurs and therefore won’t be tempted to sell any of your investments. Trust me, it doesn’t always work, but this is the role bonds play in a well-diversified portfolio.

Even if you think you are comfortable with volatility, you have to understand that experiencing a large drawdown soon after you reach FI and start living off your assets can be catastrophic to your lifestyle. We all know a 100% equity portfolio almost always outperforms a portfolio with bonds, over multiple decades.

But, for those living off their assets, the risk of running out of money is higher with a 100% equity portfolio than with a balanced portfolio of stocks and bonds, over 30 years or more. This is called sequence of returns risk. If you are unfamiliar with the concept, take my inquisitive little nephew’s advice and “search it up.” You will have your hands full with all the articles you find on this subject.

So now with a basic understanding of the role bonds play in a portfolio out of the way, let’s talk about the options you have for investing in them. The first and seemingly most straightforward way is to buy bonds directly. In today’s world, it isn’t difficult at all for an everyday investor to log in to their brokerage account and pull up an inventory of available bonds through their custodian. You can find every type of bond imaginable to invest in (Treasuries, corporates, CDs, convertibles, munis, anything), which is great from an availability standpoint.

But the purpose of this episode is not to discuss the validity of different types of bonds; instead, what I want you to understand are the differences between purchasing individual bonds directly, versus investing in a pooled investment vehicle like a mutual fund or exchange traded fund (ETF).

As I stated earlier, the argument for everyday retail investors buying individual bonds starts and ends with the fact that you cannot lose money if you hold the bond to maturity, assuming it doesn’t default. The reason for this is when you own a bond fund, it does not have a maturity date, so in theory, if interest rates were to rise into perpetuity, it is conceivable that your bond fund could lose money indefinitely. Let me pause there and take a step back because I realize many of you are probably confused. Without going into a lot of math, you need to have a basic understanding of how bond prices work.

Keeping it very simple, if interest rates go up, bond prices go down, and vice versa. This is because most bonds have a fixed interest rate attached to them. If a bond is paying 5% interest when it is issued and three years later a similar bond pays an interest rate of 8%, the 5% bond is no longer attractive, so in order to sell it, the price needs to drop to effectively turn it into an 8% bond. The opposite of this is true as well. If three years after the 5% bond is issued, a similar bond is yielding 3%, the 5% bond becomes very attractive, so investors will pay a premium to effectively make it a 3% bond. Hopefully this makes sense, and you now understand why current interest rates are the biggest factor when it comes to bond pricing.

So, back to the individual bond argument. The individual bond advocates point out that if interest rates rise, you can always just hold the bond to maturity, thereby guaranteeing you will get your money back. This of course assumes the bond doesn’t default, but regardless, the point is totally valid. However, here comes the spot in the episode where I’m going to throw cold water on everyone who thinks buying individual bonds is better.

First, while I acknowledge the fact that holding the bond until maturity does result in no loss regardless of where interest rates go, it does not mean that the bond won’t decline in price when interest rates rise. Even when you purchase an individual bond, the price changes daily, so you will see similar losses in the short-term during periods of rising interest rates.

One of my most conservative clients was never able to understand this and it drove him nuts. I remember he asked me to put a couple of his accounts into short-term U.S. Treasury bonds, which are guaranteed by the government and considered risk-free investments. Merely days after we bought them, interest rates went up a little and he called me freaking out that his Treasury bond had dropped in price.

I explained that the price reflects the current value if he were to sell them today. I had to assure him multiple times throughout the call that he would get his principal back, plus interest, if he held them until maturity. This was an extremely frustrating conversation, but a great example of how individual bonds don’t shield you from seeing your portfolio decline if interest rates go up.

Another drawback I see with individual bonds is the lack of diversification and the pricing you receive when you purchase them. Just curious, how many bonds do you think you need to feel comfortable you have a diversified bond portfolio? I’m assuming almost no one listening would consider themselves qualified to analyze a company’s financials to determine how credit-worthy they are, so if you are buying individual bonds, you will be relying 100% on ratings agencies to determine the risk level of the bond. This is fine I guess, but recognize that if you decide to buy 10 bonds and just one goes bust, that is a sizeable loss in a portfolio you are trying to keep extremely conservative.

So, now how many bonds do you think you need to buy to feel comfortable? I really don’t know. But what I do know is if you buy a bond mutual fund or ETF, they typically own hundreds of bonds. Thus, the detrimental impact of a single bond default is greatly diminished with bond mutual funds and ETFs.

Furthermore, unless you have a portfolio worth over $100 million, who do you think is going to get better prices on bonds? You, or a fund manager managing millions of dollars? When I was an advisor, I would speak to bond managers often. The best in the business would tell me stories of how companies would come to them when looking for investors, which puts the pricing power in their control. It may only be a .2 or .3 percent savings, but with bonds that is actually a pretty big deal. So you can see that using mutual funds or ETFs instantly grants you access to improved diversification and purchase pricing.

The next consideration is liquidity, which is better with bond mutual funds and ETFs. I mentioned before that many brokerage firms have good platforms to purchase individual bonds, but what happens if you need to sell yours? Again, I’m not talking to the investor who has $100 million, but instead to someone who bought a bond worth $25,000 or less. If you want to take that back to the market and try and sell it, you can, but good luck getting any type of reasonable price. No one out there needs to buy your bond, so you are unlikely to get a fair price.

On the other hand, when you own a mutual fund or ETF, you can sell your fund any time at fair market value of all the securities in the fund. As my mischievous little nephew likes to say, “things just happen,” so this could be extremely valuable in an unexpected situation.

Another point I’d like to make on the benefits of bond mutual funds or ETFs over individual bonds is about something called “roll down.” Trust me, I hate using jargon like this, but I think it is important to understand if you are going to discuss individual bonds versus bond funds. Let me try to explain the concept of roll down. If a 10-year bond has a yield of 7%, and a 1-year bond has a yield of 3%, over the early years of the 10-year bond you will see greater than a 7% return, because if that bond has a yield of 3% with only one year left, you must have seen a higher return over those early years of the investment.

I know this sounds a little technical, so if I’ve already done a fly by and this is over your head, just try to understand the big picture that in normal interest rate environments, longer-term bonds typically yield more than shorter-term bonds. So as a longer-term bond becomes a shorter-term bond, the return in its final years before maturity will be lower.

What this means is very often investors who hold individual bonds until maturity end up waiting out the last year or two with a very low interest rate compared to higher interest rates that could be gained if you owned a longer-dated bond. Since most bond funds don’t hold their bonds to maturity, they are always selling the shorter, normally lower-yielding, bonds, and replacing them with longer, higher-yielding bonds. I’ll leave it there and let you decide how valuable this is.

The final point I’m going to make in favor of mutual funds or ETFs is professional management. I don’t want to make this episode any longer than it already is, so be sure and check out the next episode of Season 3 where in Episode 5 I talk about high-yield bonds and the benefits of bond active management.

I honestly believe high-yield bonds are the most misunderstood asset class in the entire investment world. I will explain why my views towards passive management shift when it comes to fixed income. If you enjoyed this episode, I highly recommend you listen to Season 3’s Episode 5 because I will address the individual bond versus bond fund argument again.

So for those of you out there trying to determine the best way to incorporate bonds into your portfolio, the decision is now yours. I’ve made a case that the many benefits related to diversification, bond pricing, liquidity, roll down, and professional management can justify the fee charged by the mutual fund or ETF, despite its lack of a maturity date. However, as I always like to say, there is no right way to manage money, so hopefully you can use this as a resource to help you make a decision that is in your best interest.

I sure hope you enjoyed this episode of Invested Poorly and will be able to take something from it to improve your decision making as you navigate the twists and turns of your personal investing adventure. Be sure to check out my website at AreYouFI.com (that’s A R E Y O U F I dot com) where you can find resources and show notes with the charts and graphs I mention during the episodes. These are like little treasure maps that can help you choose more wisely along your quest to reach FI, or financial independence.

Never forget, in the short-term the stock market is unpredictable, and as my mischievous little nephew likes to say, “things just happen!” So focus on the long-term, by controlling your emotions, simplify your investments, and always… ignore the noise.

I’m your host, Jeff Harrell. Thanks for listening.

Invested Poorly: Sad Tales of FInancial Fails was created for informational purposes only and should not be relied on for specific tax, legal, or investment advice. You should consider consulting a qualified professional to review your situation before engaging in any transactions. Investing involves risk, including loss of principal and past performance is no guarantee of future results.

This podcast was produced by Ted Cragg. Learn more about creating podcast mini-series like this by visiting QuickEditPodcasts.com.