Is there any reason to buy individual bonds instead of funds

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Is there any reason to buy individual bonds instead of funds

Postby Day9 » Mon Mar 25, 2013 2:25 am

Is there reason to buy individual bonds nowadays when there are low-cost bond funds like BND/VBTLX?

An individual nominal bond held to maturity will have increasing real returns in a deflationary environment. Is the same true in bond funds? I'm racking my brains trying to think of a situation where one would prefer individual bonds over a fund.

Thanks
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Re: Is there any reason to buy individual bonds instead of f

Postby Valuethinker » Mon Mar 25, 2013 4:20 am

Day9 wrote:Is there reason to buy individual bonds nowadays when there are low-cost bond funds like BND/VBTLX?

An individual nominal bond held to maturity will have increasing real returns in a deflationary environment. Is the same true in bond funds? I'm racking my brains trying to think of a situation where one would prefer individual bonds over a fund.

Thanks


If you hold individual bonds you have constantly shrinking duration and maturity.

As a result, you are more insensitive to rises in interest rates. A bond fund has to crystallize losses (or gains) by selling bonds when they fall below its minimum maturity criterion. Or to match the benchmark duration and maturity (same thing, really).

Total Bond fund does not 'index' per se, and can avoid that- -it can hold bonds to maturity, I believe (does it sell them when they have less than 1 year to maturity?). There is a cleverness associated with passively managing a bond fund but not being an actual index tracker, due to the nature of bond benchmarks.

I do know TBM took a hit in 2000 era over telecoms bonds, and therefore watches its sector exposure. Similarly they appear to have been clever with Mortgage Backed Securities-- reducing the weighting from 40% to 25% (?) and also holding MBS that are less exposed to extension risk.
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Re: Is there any reason to buy individual bonds instead of f

Postby Call_Me_Op » Mon Mar 25, 2013 5:50 am

Individual bonds provide:

1.) Precise control over maturities

2.) Elimination of manager risk

3.) Elimination of "sell-off risk", also called "redemption risk"

However, you may have increased exposure to default risk unless you hold treasuries.
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Re: Is there any reason to buy individual bonds instead of f

Postby nisiprius » Mon Mar 25, 2013 6:28 am

Yes, there can be. However, speaking as someone who owns individual TIPS issues, owning individual bonds is a royal PITA, and as others have noted you would be worried about default risk unless you owned very high quality issues and/or Treasuries. I don't recommend it. I think it is most appropriate for reasonably wealthy--"high net worth"--individuals, who can easily afford to buy many different issues of bonds, buying at least $10,000 of every issue--and who have someone to manage their portfolio for them.

The reason I say there can be is this. An individual bond has a characteristic that makes it completely different from a stock, which is the fact that it has known value at one specific known future date, the date of maturity. You buy, say, a 10-year Treasury for about $1,000, and the day it matures it pays you back the $1,000 (plus the final interest payment). You can't make an "early withdrawal" from a bond--the whole reason the issuer issued the bond was to have the full use of your $1,000 for the full ten years. If you need money from a bond before maturity, the only way you can get money from a bond is to sell it on the market, where it is subject to fluctuations in value.

With a stock, the only way to get money from it is to sell it on the market, period. With a bond, however, you do not need to expose yourself to the market--you can just let the bond mature. Furthermore, since the bond is known by everyone to pay $1,000 on (say) March 15th, 2023, obviously the market value of that bond must be very close to $1,000 the day before maturity. The market value of a bond is anchored at both ends and fluctuates at the middle.

Does this matter? Whether it matters or not depends on your plans for the individual bond and whether you can carry out those plans. If you regard bonds as just an amorphous blob of assets that you buy and sell as needed, e.g. to rebalance, then you will often be buying or selling them on the market and experiencing the fluctuation. However, if you have a plan which involves mostly letting the bonds mature, you do not experience market fluctuation. This is called "matching assets with liabilities." A clear example would be, say, a manager of a pension that pays fixed-dollar amounts. The manager knows that he will need to pay Bob Cratchit $1,000 in January 2023, $1,000 in February 2023, $1,000 in March 2023, etc. So he buys bonds that mature on those dates and pay out $1,000 on each of them, and then he's set. Nothing the market does will affect his ability to make those payments.

You will see from this that individual bonds make the most sense in terms of liability matching, i.e. building a bond ladder to provide retirement income, as opposed to accumulating a nest egg.

Liability matching? An advantage to individual bonds. No liability matching, just buying and selling at arbitrary times? An advantage to mutual funds, particularly convenience and diversification.

A bond fund is a collection of bonds that mature at different times, so when you buy or sell it, you are always experiencing market fluctuations.

(There is an ideology thing that may come up. You will have to decide for yourself how you feel about it. Like all ideologies, the people on each side insist that there is no room for argument and that their side is objectively correct. It revolves around this question: does the market value of an asset matter if you have no intention of buying it or selling it? In the example above, suppose that the pension manager discovers that the bond he bought to meet Bob Cratchit's $1,000 monthly payment in February, 2023 has a market value today of $500? Assuming that the bond does not default and will meet the payment as planned, exactly what significance does the $500 value have?)
Last edited by nisiprius on Mon Mar 25, 2013 6:32 am, edited 1 time in total.
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Re: Is there any reason to buy individual bonds instead of f

Postby assumer » Mon Mar 25, 2013 6:31 am

Have you seen our wiki page discussing this?
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Re: Is there any reason to buy individual bonds instead of f

Postby vesalius » Mon Mar 25, 2013 7:02 am

Then there are the target date bond funds that hold bonds with only a specific maturity date/year. When that target date is reached the fund closes with investors getting back their principal minus expenses.

These type funds should really help protect investors from default risk of individual bonds, as well as, protecting you from market fluctuations, if you hold the fund to its maturity date. You will obviously pay for both of these protections through the funds expense ratio.

Does anyone have any experience with or comments upon these funds that seem to be a hybrid between the more standard bond funds and individual bonds?

iShares has a national AMT free muni line up, described below in an index universe article.

iShares Adds 2018 Rung To Muni Lineup
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Re: Is there any reason to buy individual bonds instead of f

Postby Doc » Mon Mar 25, 2013 11:20 am

nisiprius wrote: However, speaking as someone who owns individual TIPS issues, owning individual bonds is a royal PITA ...

The bookkeeping associated with bond premium amortization/accretion and original income discount should become much less of a PITA starting in 2014 (earlier with some brokers) because the new IRS reporting rules go into effect then.
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Re: Is there any reason to buy individual bonds instead of f

Postby wshang » Mon Mar 25, 2013 4:05 pm

Sure, several more. Tax loss harvesting, avoiding the drag from other investors churning the fund and forcing the manager to hold liquid a portion. I might even argue in this environment with PUNY yields, the advantages of owning your own bonds are increased over when interest rates are higher. Finally, there is no reason why you should pay any fee to have a fund hold your Treasuries - in my mind, that is just needlessly giving money away.
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Re: Is there any reason to buy individual bonds instead of f

Postby JAIrwin » Mon Mar 25, 2013 4:46 pm

assumer wrote:Have you seen our wiki page discussing this?


Thanks so much for sharing the wiki link! I've been looking for a good reference about this as well because I was believe in Larry Swedroe's books that I read, he states that investing in actual bonds is more efficient than investing in bond mutual funds. However, for me, it is just less of a headache to have a bond index fund since I have a relatively small asset base at the moment (around 200k).
Jacob Irwin, graduate student/PF blogger
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Re: Is there any reason to buy individual bonds instead of f

Postby connya » Mon Mar 25, 2013 6:01 pm

Even aside from someone looking for liability matching in retirement, does holding individual treasury bonds and "riding the yield curve" provide a benefit? Under Larry's 20 bps per year rule, you would only buy 52-week bills today until rates become more reasonable. This doesn't involve market prediction and sounds appropriate for our current environment. You also avoid the (low) ER of a fund.

The only real downside I can see is the fluctuating average maturity, but would this approach make sense for an investor who didn't require a specific maturity?

This is assuming you are holding treasuries in the first place, of course.
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Re: Is there any reason to buy individual bonds instead of f

Postby wshang » Tue Mar 26, 2013 4:02 pm

BND at the time of this writing has the highest level of unrealized gains ever:
"A fund which defers gains realization accumulates unrealized appreciation, which when distributed, will be taxed; thus the unrealized gain/loss figure shows the potential gain (or loss) that would be realized if the portfolio was to be entirely liquidated. "
-boglewiki

BND has a turnover rate of 80% which is not reflected (to my knowledge) in the expense ratio.

By comparison, my own bond portfolio has a turnover rate a fraction of that since I only buy and never sell.
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