Bond mutual fund vs individual bonds

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ginmqi
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Bond mutual fund vs individual bonds

Post by ginmqi »

Young investor here trying to learn asset allocation for the long run. I totally agree with index funds for the equity market. 100%. But as I am reading more about bonds (since they are a bit more complicated to understand, in my mind anyway, than equity) it seems that bonds are a quite different animal than stocks. There are many different types of bonds and they have different risk profile than stocks.

Premise: Main role of bonds is to preserve capital and weather the storm. Thau in her book "The Bond Book" says that a rule should be similar to the Hippocratic Oath: "Do no harm"

I first read Swensen's book who says that the only bonds that should be in an investor Core Asset Class are: US treasury bonds and TIPS (short-term munis may be ok). But of course this means the Total Bond Market index fund would go against that recommendation.

So this is question #1: If the philosophy behind bonds is to be a counter-balance against stocks...then does it make sense to only invest the safest possible bonds? Aka, only invest in US treasury and TIPS. Why take ANY risk in munis/coporates/foreign/etc. that will be riskier by definition than US treasuries?

Then as I finished my first read of The Bond Book. Thau lays out some pluses and minus of bond funds vs individual bonds.

Bond Fund - disadvantages
-Unlike a single bond, a bond fund has no guarantee maturity date. It seems that the bond funds are at the whims of the market....that is the bond market. The value of the bond fund goes up and down with respect to interest rates and also as buyers/sellers move in and out of that market.

-You cannot know for sure that you will recoup your original principal plus the coupon interest and revinesting that coupon.

-Duration of a bond fund is the same year after year....vs a bond where the duration decreases as the years go by, hence interest rate risk gradually reduces. Bond fund's interest rate risk is never reduced.

-Expenses/fees. Even Vanguard cannot offer mutual funds for free. There is an annual fee, albeit very low, that is the entry/maintenance price into the bond fund asset class. Whereas individual bonds from US treasury bought from TreasuryDirect have no annual "fees" and no "commissions." (as far as I understand)

After some reading. It seems to me the safest strategy is to have a portfolio of laddered, short to intermediate-term treasuries (and some TIPS), always hold to maturity while continue the laddering. This essentially eliminates credit quality risk (US govt, if you do not trust in the US govt to be around in the next 30 years, then probably no use investing in things other than prepper bunkers and canned foods...) and also "eliminates" interest rate risk because if you ALWAYS hold to maturity you do not worry about price fluctuations because your will redeem the bond at par + coupon, and also you eliminate 100% of any expenses/fees.

Again, I am learning and I would appreciate the collective wisdom/advice of the Boglehead forum.

edit: This is assuming that one wants the safest place for their bond money. So only US Treasuries and TIPS. If one were to invest in corporate/foreign/munis bonds, then I can see role for a fund of bonds. But this is another questions.....why invest in those riskier bonds at all? So if we only want US treasuries...then individual, laddered bonds are the way to go it seems.
sscritic
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Re: Bond mutual fund vs individual bonds

Post by sscritic »

Some of the collective advice is in the wiki, where there is a page specifically addressing this topic.

Just to make you click twice, here is my post from Wednesday giving the link to the wiki article.
http://www.bogleheads.org/forum/viewtop ... 5#p2030725

P.S. That thread had a very similar title: Individual bonds VS bond fund, but it reversed the order of fund and individual.
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ogd
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Re: Bond mutual fund vs individual bonds

Post by ogd »

Use funds, even for Treasuries. Thau's points have little or no applicability to a young investor with access to Vanguard funds.

1) All bonds are at the whims of the bond market. You can choose to ignore it and pretend you're fine with waiting 5 years making much less interest than everyone else, but the losses are the same either way. A bond does not behave any differently just because it's part of a fund.

Ignoring the market value of a bond could mean you're actively hurting yourself by not understanding just how little your bond capital is making you. For example, an old 10% coupon bond maturing next year trades at such a premium that it will actually make only about 0.1%, like all other 1 year bonds. By selling the bond at its huge market value and putting the money in a savings account you can easily make 1%. That 0.9% difference is an objective reality, and not a choice of perception.

2) As an investor with an ongoing bond allocation, you don't care about any specific point in time. Nor do you care about reducing durations. With a ladder you know you get, say, 10% of your par value every year, but the value of the rest is up to the market just like with a fund. You then take that par value and put it back in the market, much like a fund but with a lot more work. I suppose you could consider it a hobby.

3) If you did care about a specific point in time, e.g. targeting a known expense, you'd use zero coupon bonds that don't pay you interest you don't need along the way, not a ladder of coupon bonds. You'd never reinvest the proceedings. Any time you reinvest a bond's par value, you've wasted your time compared to being in a fund.

4) Vanguard funds are so cheap that the expense argument is out the window.

5) If you later change your mind about the fixed point in time, for example, you can still sell the fund (possibly at a loss) and buy the ladder (whose market prices took a similar loss), and run it out going forward. Better yet, buy zero coupon bonds which do what you actually want.

That said, if you want to do this with Treasuries and TIPS, it's not the worst thing in the world because they're safe and liquid and you won't get gipped by institutional traders like in the muni markets, for example. It could be a learning experience and a hobby.

As for other types of bonds:
Munis: very worth it if you need bonds in taxable accounts and you are in a high tax bracket. Otherwise, not so much.
Corporates: less of a clear case particularly for a young investor with a high equity allocation. Like you said, you could just get stocks instead. But high quality corporates are safe enough that it doesn't make a huge difference.

Overall: the difference between any of these choices will be insignificant in your portfolio. Focus on stocks and particularly your career, both of which matter orders of magnitude more.
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Re: Bond mutual fund vs individual bonds

Post by ogd »

To address a specific point:
ginmqi wrote:... also "eliminates" interest rate risk because if you ALWAYS hold to maturity you do not worry about price fluctuations because your will redeem the bond at par + coupon, ...
No, it doesn't eliminate interest rate risk. You know what does? Cash. Compare:

1) I have cash. Interest rates go up to 5% tomorrow. I put that cash in a 10 year bond and make 50% in coupons
2) You have a 10 year bond. Interest rates ... you've guessed it. You are forced to hold it for 10 years, making 25% in coupons.

That 25% difference is your interest rate risk. You are not in the same boat as me. But you are in the same boat as:

3) Joe has a 10 year bond that he chooses to mark to market, or a 10 year fund. Interest rates go up to 5%. Joe takes a grievous loss of 20%, but he starts making 5% a year yield to maturity on the remaining money right away. He gets a total of 40% in yield, which combined with the loss means he's up 20% vs your 25%; the remaining 5% is the difference of his reinvesting 5% a year vs your 2.5% a year.

So there. Interest rate risk does not go away because you choose to ignore the market. Unless you can take your par out tomorrow at little or no loss, you have interest rate risk.
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Re: Bond mutual fund vs individual bonds

Post by Doc »

ogd wrote:As an investor with an ongoing bond allocation, you don't care about any specific point in time.
A possible exception to worrying about a specific point in time would be if you needed to sell bonds unexpectedly to meet some emergency or to re-balance into equities during a stock market crash. But even this situation can be addressed with funds if you have several funds with different durations which would give you the option of which was best to sell at that time.
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ogd
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Re: Bond mutual fund vs individual bonds

Post by ogd »

Doc wrote:
ogd wrote:As an investor with an ongoing bond allocation, you don't care about any specific point in time.
A possible exception to worrying about a specific point in time would be if you needed to sell bonds unexpectedly to meet some emergency or to re-balance into equities during a stock market crash. But even this situation can be addressed with funds if you have several funds with different durations which would give you the option of which was best to sell at that time.
Yes, an individual bond is something that doesn't give you emergency capabilities -- you need to wait for the remainder of the term. Cash and short-term funds are best.

When it comes to rebalancing into a crash though, I'm not setting aside cash for that. Not only will bond losses be very small by comparison (or bonds might likely have gone up), but also I don't stigmatize selling bonds at a loss. Going forward you give up the current market yield over the remainder of the term, no more, no less, whether you sell at a loss or a big gain or at par. Just like you'd expect from a rebalancing exercise.
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Re: Bond mutual fund vs individual bonds

Post by Doc »

ogd wrote:
Doc wrote:
ogd wrote:As an investor with an ongoing bond allocation, you don't care about any specific point in time.
A possible exception to worrying about a specific point in time would be if you needed to sell bonds unexpectedly to meet some emergency or to re-balance into equities during a stock market crash. But even this situation can be addressed with funds if you have several funds with different durations which would give you the option of which was best to sell at that time.
Yes, an individual bond is something that doesn't give you emergency capabilities -- you need to wait for the remainder of the term. Cash and short-term funds are best.

When it comes to rebalancing into a crash though, I'm not setting aside cash for that. Not only will bond losses be very small by comparison (or bonds might likely have gone up), but also I don't stigmatize selling bonds at a loss. Going forward you give up the current market yield over the remainder of the term, no more, no less, whether you sell at a loss or a big gain or at par. Just like you'd expect from a rebalancing exercise.
Why can I sell a fund anytime but need to wait for the remainder of the term to sell a bond? If this is your experience I suggest you find another broker.

Who's talking about cash?

Suppose you need $1000. Which is better selling 1/2 of a $2000 five year fund or being able to choose between selling either a 2 year note or an 8 year $1000 note? The second lets you choose given the yield curve and your tax situation at the time. The first gives you no choice. I contend more choice at no cost is better in this limited circumstance.

Perhaps you missed "if you needed to sell bonds ...". Now if you had to sell your entire bond portfolio individual bonds or a fund with the same duration give you essentially the same result.
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Re: Bond mutual fund vs individual bonds

Post by ogd »

Doc wrote:Why can I sell a fund anytime but need to wait for the remainder of the term to sell a bond? If this is your experience I suggest you find another broker.
The discussion was about being forced to sell a bond at a loss / bad time. If you want to avoid the loss, you need to wait. Bond funds of longer terms are equally not good for this, which is why I said cash or short.
Doc wrote:Suppose you need $1000. Which is better selling 1/2 of a $2000 five year fund or being able to choose between selling either a 2 year note or an 8 year $1000 note? The second lets you choose given the yield curve and your tax situation at the time. The first gives you no choice. I contend more choice at no cost is better in this limited circumstance.
I will sell one half and move the rest into a longer term fund matching your duration (which you've just extended). I challenge you to show that in the long term there's any difference difference.

Yes, it's more complicated. But you know what? I refuse to have any more arguments where you start with a ladder, do a move that's easier with a ladder, then ask me to match it with funds and argue it's harder. It doesn't really show anything, since there are an equal number of moves that are much easier with a fund, e.g. rebalance while maintaining the previous shape, or, you know, not change anything whereas the ladder requires frequent maintenance. I don't view that kind of argument as productive in the current thread.

Instead, I will point out that a fund plus cash up to the desired duration not only is more flexible by allowing me to have as much short term as I want as opposed to being accidental to the ladder, but in the current situation with cash paying 1% outside the bond market, the combination makes quite a bit more. And that's that for the emergency aspect as far as I'm concerned.
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Re: Bond mutual fund vs individual bonds

Post by Doc »

ogd wrote:I will sell one half and move the rest into a longer term fund matching your duration (which you've just extended). I challenge you to show that in the long term there's any difference difference.
I have a ten year note with a 4% coupon with two years left to maturity. That note is selling at a premium because the current yield on a two is only 1%. I can convert that premium to LTCG and pay tax at a lower rate than allowing it to mature and paying ordinary income tax on that "extra" coupon. Selling the longer fund and reinvesting the extra converts whatever LYCG I had on that extra to ordinary income.

There are other possible scenarios that can give you some advantage provided you have a choice. With a single fund you remove that choice. Does it make much difference. Sometimes. Last year I sold some short term TIPS with a high coupon and converted that gain to LTCG instead of holding until maturity and paying tax at higher rate. If I was holding a short term TIPS fund instead I would not have had that choice.

Stop arguing. You posted a long list of why individual bonds and mutual funds were essentially equivalent. Most of them are very valid considerations. One needed a small tweak. So what. I already said that my point is made mute by holding funds of two or three durations thus validating your original idea.
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Re: Bond mutual fund vs individual bonds

Post by jbaron »

The financial definition of "risk" is the chance that an actual return will be different than an expected return.

If your horizon is exactly ten years, and you purchase a ten year, zero coupon bond (or zero coupon TIPS bond, if you care about inflation) then by definition, your risk is zero, because you know now, at this very minute, when you purchase that bond, what your return will be over the next ten years.

If instead, you keep your money is cash, there is risk because your return may be different than what you might currently expect it to be over the next ten years.
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Re: Bond mutual fund vs individual bonds

Post by ogd »

jbaron: the problem with using that definition of risk for interest rates is 1) the OP does not have a known horizon, few people do with certainty, cue in the discussion of rebalancing into an equity crash, and 2) I would call the prospect of underperforming cash under certain circumstances a risk, definitions be damned. There's something strange about a definition that goes entirely against the market pricing. Folks are willing to pay quite a bit more for shorter bonds than for longer ones; there are rare circumstances when reinvestment risk reverses the curve, but most of the time interest rate risk dominates, as people don't worry much about the former, or alternatively they welcome the positive side of the uncertainty in your definition.
Doc wrote:Stop arguing.
Alright. For what it's worth though, VFIUX, the IT Treasury fund, which is narrow and liquid enough for this activity, did distribute about half again its dividend as LTCG last quarter and in 2013, so you do get that benefit to a degree. It's true that for some (e.g. with no capital loss carryovers), having the choice of timing would be even better.
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Re: Bond mutual fund vs individual bonds

Post by grayfox »

jbaron wrote:The financial definition of "risk" is the chance that an actual return will be different than an expected return.

If your horizon is exactly ten years, and you purchase a ten year, zero coupon bond (or zero coupon TIPS bond, if you care about inflation) then by definition, your risk is zero, because you know now, at this very minute, when you purchase that bond, what your return will be over the next ten years.

If instead, you keep your money is cash, there is risk because your return may be different than what you might currently expect it to be over the next ten years.
Correct.

Responding to the OP:
An individual Treasury bond pays a certain amount on a certain date, so is very predictable. A point outcome. Standard deviation = 0 at maturity.
A Treasury bond fund has a distribution of outcomes so is less predictable. A range of possible outcomes. There is some standard deviation.
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Re: Bond mutual fund vs individual bonds

Post by LarryG »

Several years ago I used a 5 year ladder of Treasuries (which Annette Thau described as a do-it-yourself mutual fund). This worked well.
With the drop in interest rates, I switched to Vanguard Total Bond Market Index Fund, aware of the quality difference. I believe that this is partially compensated by the wide diversification in the fund.
At present I use Vanguard Target Retirement Income Fund so the difference becomes moot.
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Re: Bond mutual fund vs individual bonds

Post by dl7848 »

Premise: Main role of bonds is to preserve capital and weather the storm. Thau in her book "The Bond Book" says that a rule should be similar to the Hippocratic Oath: "Do no harm"
That premise works for young investors, which you say you are. Some of the confusion regarding bonds comes because investors who are nearing retirement, or in retirement, may become more income-oriented, and also want to reduce the risk from equities. If the prevailing environment is one of low interest rates, the near-retirees may want income that is higher than that attainable via Treasuries or other safe bonds. They may instead gravitate towards corporate bonds, high-yield bonds, emerging market bonds and so on...in order to get the extra income. There are many pros and cons to this strategy, but in the end, it works out that these income-oriented investors would rather not sell equity shares to pay their bills, and in fact may drastically downsize their equity holdings. But they do want a steady stream of income. That makes the higher income from non-Treasuries attractive to them.

The non-Treasuries like HY may have lower interest-rate risk but they have higher credit risk, or in the case of EM bonds, the unique political, etc. risk associated with countries that may play by a different rule book. However, many people believe that non-Treasuries are less risky than equities, and so the risk is considred acceptable by many retirees or near-retirees. They essentially sell most of their equities and buy riskier bonds instead., usually backed up with some of the safer bonds. Some even "barbell" high-credit-risk bonds with high-interest-rate-risk bonds, as sort of a compromise.

These non-Treasury types of bonds are not for individuals to handle on their own and generally need an active manager, or at the very least, need to be in some sort of fund to spread the risk via a diversified set of holdings
So this is question #1: If the philosophy behind bonds is to be a counter-balance against stocks...then does it make sense to only invest the safest possible bonds?
That only holds if you actually agree that the only role of bonds is to counter-balance stocks. As illustrated before, that is not necessarily a consensus opinion (though it may be the consensus opinion on this board).
Bond Fund - disadvantages

-You cannot know for sure that you will recoup your original principal plus the coupon interest and revinesting that coupon.
Correct. But some people are more concerned about income and would rather have a steady stream of income, even if it means a potential loss of principal, either temporarily or over the long term. So one can start by deciding if one is an income investor or looking for long-term capital appreciation. If the latter, going heavy on stocks with some Treasuries or other "safe" bonds as ballast is the way to go. In which case, you can either go with a ladder, or use bond funds, but it might not be a bad idea to DCA. On the other hand, as you grow older, you may become more curious about the strategies embraced by some income-oriented investors, in which case, you'd research into high yield, EM, and global bonds, etc.
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Re: Bond mutual fund vs individual bonds

Post by ginmqi »

ogd wrote:Use funds, even for Treasuries. Thau's points have little or no applicability to a young investor with access to Vanguard funds.

1) All bonds are at the whims of the bond market. You can choose to ignore it and pretend you're fine with waiting 5 years making much less interest than everyone else, but the losses are the same either way. A bond does not behave any differently just because it's part of a fund.

Ignoring the market value of a bond could mean you're actively hurting yourself by not understanding just how little your bond capital is making you. For example, an old 10% coupon bond maturing next year trades at such a premium that it will actually make only about 0.1%, like all other 1 year bonds. By selling the bond at its huge market value and putting the money in a savings account you can easily make 1%. That 0.9% difference is an objective reality, and not a choice of perception.

2) As an investor with an ongoing bond allocation, you don't care about any specific point in time. Nor do you care about reducing durations. With a ladder you know you get, say, 10% of your par value every year, but the value of the rest is up to the market just like with a fund. You then take that par value and put it back in the market, much like a fund but with a lot more work. I suppose you could consider it a hobby.

3) If you did care about a specific point in time, e.g. targeting a known expense, you'd use zero coupon bonds that don't pay you interest you don't need along the way, not a ladder of coupon bonds. You'd never reinvest the proceedings. Any time you reinvest a bond's par value, you've wasted your time compared to being in a fund.

4) Vanguard funds are so cheap that the expense argument is out the window.

5) If you later change your mind about the fixed point in time, for example, you can still sell the fund (possibly at a loss) and buy the ladder (whose market prices took a similar loss), and run it out going forward. Better yet, buy zero coupon bonds which do what you actually want.

That said, if you want to do this with Treasuries and TIPS, it's not the worst thing in the world because they're safe and liquid and you won't get gipped by institutional traders like in the muni markets, for example. It could be a learning experience and a hobby.

As for other types of bonds:
Munis: very worth it if you need bonds in taxable accounts and you are in a high tax bracket. Otherwise, not so much.
Corporates: less of a clear case particularly for a young investor with a high equity allocation. Like you said, you could just get stocks instead. But high quality corporates are safe enough that it doesn't make a huge difference.

Overall: the difference between any of these choices will be insignificant in your portfolio. Focus on stocks and particularly your career, both of which matter orders of magnitude more.
Thanks for insightful advice. Although I'm afraid that my current understanding and vocabulary of the bond universe does not allow me to understand 100% of what you have posted.

With the very real presence of the bond market, of course it is subject to interest rate risk and the value of the bond will go up or down...but with a rolling ladder, should that not mitigate it? Also rolling ladder would means there are multiple bonds so I don't have to wait 5 years for a bond to mature and lose out on the higher interest environment of that 5-years if that were the case. Each year comes along and invest in the bond to replace that top rung of the ladder.

Also can you explain more regarding the 10% bond making only 0.1%? If someone has a bond with 10% interest then why would they want to sell it at the secondary market? Just hold it to maturity to collect that yield at the end?

I'm delighted that in the end this debate is not of too huge of an impact to the overall portfolio. I definitely agree that sound investing in equity and of course investment in yourself with your career and lifetime earnings are going to pack majority of the punch.
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Re: Bond mutual fund vs individual bonds

Post by ginmqi »

ogd wrote:To address a specific point:
ginmqi wrote:... also "eliminates" interest rate risk because if you ALWAYS hold to maturity you do not worry about price fluctuations because your will redeem the bond at par + coupon, ...
No, it doesn't eliminate interest rate risk. You know what does? Cash. Compare:

1) I have cash. Interest rates go up to 5% tomorrow. I put that cash in a 10 year bond and make 50% in coupons
2) You have a 10 year bond. Interest rates ... you've guessed it. You are forced to hold it for 10 years, making 25% in coupons.

That 25% difference is your interest rate risk. You are not in the same boat as me. But you are in the same boat as:

3) Joe has a 10 year bond that he chooses to mark to market, or a 10 year fund. Interest rates go up to 5%. Joe takes a grievous loss of 20%, but he starts making 5% a year yield to maturity on the remaining money right away. He gets a total of 40% in yield, which combined with the loss means he's up 20% vs your 25%; the remaining 5% is the difference of his reinvesting 5% a year vs your 2.5% a year.

So there. Interest rate risk does not go away because you choose to ignore the market. Unless you can take your par out tomorrow at little or no loss, you have interest rate risk.
I think I see what you're saying here. But again with a rolling ladder, (and I've read that in general avoid a bond with as long of a duration as a 10-year bond would give you...) wouldn't you have bonds maturing each year and so you then have the cash to basically reinvest into a more favorable interest rate environment?

But yes, all bonds are subject to interest rate risk. That seems to be a fundamental concept to understand with bonds.
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Re: Bond mutual fund vs individual bonds

Post by steve_14 »

ginmqi wrote:So this is question #1: If the philosophy behind bonds is to be a counter-balance against stocks...then does it make sense to only invest the safest possible bonds? Aka, only invest in US treasury and TIPS. Why take ANY risk in munis/coporates/foreign/etc. that will be riskier by definition than US treasuries?
I asked the same question just last week: http://www.bogleheads.org/forum/viewtop ... 9#p2030359 and got a wide variety of opinions, none of which convinced me I needed to clutter my portfolio with the risks and complexities of agency and corporate bonds (though I admit total bond market funds are so low risk it doesn't matter much).

On the stock side, owning a total market fund does maximize risk/return efficiency. Diversification is a free lunch. But you can't apply this to the bond market, which includes all sorts of complex contracts. Take your risk on the stock side I say.
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Re: Bond mutual fund vs individual bonds

Post by ogd »

ginmqi wrote:Also can you explain more regarding the 10% bond making only 0.1%? If someone has a bond with 10% interest then why would they want to sell it at the secondary market? Just hold it to maturity to collect that yield at the end?
Here's a concrete example from the WSJ treasury quote page, from Friday:

Maturity Coupon Bid Asked Chg Asked yield
8/15/2015 10.625 113.7422 113.6406 0.0859 0.129

You could sell this bond now and collect $113.75. Or you can wait, collect 10.625% coupons for another 5 quarters, but get only $100 back. Which means that by waiting, you only make another 0.129%, which you can easily beat in a savings account. This Treasury is no longer a good investment for an individual investor. In essence, the market is willing to give to you those high coupons now, and you should take it. The pricing makes complete sense if you think about it from the perspective of both the seller (who's not willing to accept less money given those coupons) and the buyer (who is willing to pay this much because it's comparable to current Treasury yields around one year, but no more).
ginmqi wrote:With the very real presence of the bond market, of course it is subject to interest rate risk and the value of the bond will go up or down...but with a rolling ladder, should that not mitigate it? Also rolling ladder would means there are multiple bonds so I don't have to wait 5 years for a bond to mature and lose out on the higher interest environment of that 5-years if that were the case. Each year comes along and invest in the bond to replace that top rung of the ladder.
If you have a ladder of 5 year bonds, you'll need to wait an average of 2.5 years for your bonds to mature. The same would happen for a bond fund with duration 2.5 years, and they'll yield about the same. Longer funds and longer ladders need to wait more. Now the fund may not actually wait for its bonds to mature, but this doesn't matter, by the reverse argument to the one above: it can either wait to maturity and make less coupon, or sell early at a loss but start making the higher yields right away; by the time the bond's maturity elapses the fund will have made the same money either way.

An important thing to remember about bond pricing is that all bonds of the same maturity and issuer are priced to yield the same, whether old or new, so you can switch between them at will, and bond ladders and shapes ultimately make very little difference. This should be crystal clear to you, btw, before venturing into individual bonds, particularly if you have to pay taxes, whereby decisions like taking coupons vs selling will acquire some additional importance. Some (like Doc) say you can optimize taxes better than a fund this way; perhaps, but it doesn't seem worth the hassle and I'm pretty sure the fund does some optimization of its own.

But in summary, having the same bond outside the fund doesn't magically protect if from interest rate risk. It only allows you to ignore the market price, sometimes to your detriment.
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Re: Bond mutual fund vs individual bonds

Post by berntson »

You're getting lots of great advice in this thread. I'll throw in my two cents. I don't have any bonds but, if I did, I would own treasuries. For convenience, I would put the money in an index fund during the year. Then, at the end of the year, I would sell the fund and put the money in a bond ladder.

For a few minutes of your time once a year, you can save a bit in fees. If you have $200,000 in bonds, it works out to $200 a year. And you get the satisfaction of owning at least some assets directly.
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Re: Bond mutual fund vs individual bonds

Post by ogd »

berntson wrote:For a few minutes of your time once a year, you can save a bit in fees ($10 a year for every $10,000 invested in bonds). And you get the satisfaction of owning at least some assets directly.
Huh? I'm pretty sure the fees get deducted from coupons throughout the year and not just on a "fee day" to be avoided.

Also, please stay out of my Treasury fund with that freeloader mentality :mrgreen:
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Re: Bond mutual fund vs individual bonds

Post by Doc »

berntson wrote:For a few minutes of your time once a year, you can save a bit in fees. If you have $200,000 in bonds, it works out to $200 a year. And you get the satisfaction of owning at least some assets directly.
You are underestimating the cost saving. For example if you are using say a ten year ladder you could save $13 per year for a $10k investment over the exorbitant fee of 0.13% charged by ITE - SPDR Barclays Intermediate Term Treasury ETF.
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Re: Bond mutual fund vs individual bonds

Post by berntson »

ogd wrote:
berntson wrote:For a few minutes of your time once a year, you can save a bit in fees ($10 a year for every $10,000 invested in bonds). And you get the satisfaction of owning at least some assets directly.
Huh? I'm pretty sure the fees get deducted from coupons throughout the year and not just on a "fee day" to be avoided.

Also, please stay out of my Treasury fund with that freeloader mentality :mrgreen:
Ha! I can see how my post can be read that way. :D

Suppose an investor saves $40,000 a year and typically puts $10,000 of that in bonds. She invests new money on a bi-monthly basis. Now, she could buy bonds for her ladder twice a month. But that's more work than it's worth, since it will save her only a few bucks. And she will have lots of ridiculously small bond purchases. So instead, she puts everything in a bond fund and pays all relevant fees until December 31st.

On January 1st, she then moves all $10,000 from her bond fund into her bond ladder with a single bond purchase. Less work and and a simpler bond ladder. And she saves $10 to $15 a year on that $10,000 for the rest of her life (or until she spends it).

Alternatively, our hypothetical investor could just leave the $10,000 in cash and buy bonds once a year. That would be fine too.
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Re: Bond mutual fund vs individual bonds

Post by Cody »

Not seeing much here that helps with the OP's subject line. What about bond mutual funds?

Do they provide "almost" the same results as individual bonds.

Are they close enough to say its a draw?
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Re: Bond mutual fund vs individual bonds

Post by ogd »

berntson wrote:Ha! I can see how my post can be read that way. :D
:oops: Got it. My bad.

One problem for me is that the bond ladder doesn't last forever, it needs constant maintenance. To each his own whether the expenses are worth it. And outside Treasuries, a fund wins on diversification alone.
Cody wrote:Not seeing much here that helps with the OP's subject line. What about bond mutual funds?

Do they provide "almost" the same results as individual bonds.

Are they close enough to say its a draw?
The fruitful discussion was earlier in the thread. :)

They are the same thing. More diversification and less hassle for fund, no expenses for individual bonds. Interest rate risk advantages are illusory. That's my summary.
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Re: Bond mutual fund vs individual bonds

Post by gerrym51 »

i have the 2023 version of these.

a fund of bonds held to term and fund will terminate at set date.


https://www.fidelity.com/mutual-funds/n ... rity-funds
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Re: Bond mutual fund vs individual bonds

Post by Doc »

ogd wrote:They are the same thing. More diversification and less hassle for fund, no expenses for individual bonds. Interest rate risk advantages are illusory. That's my summary.
The highlighted phrase is the most important takeaway.

If we are comparing a rolling ladder and a mutual fund in isolation they provide essentially the same risk/reward profile.

A fund has the advantage of no hassle and is very easy for small investor to utilize.

The ladder has a very slight cost advantage and provides more flexibility if one wants/needs to sell some FI to meet emergencies or rebalance in flight to quality situations.
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Re: Bond mutual fund vs individual bonds

Post by berntson »

Doc wrote:
berntson wrote:For a few minutes of your time once a year, you can save a bit in fees. If you have $200,000 in bonds, it works out to $200 a year. And you get the satisfaction of owning at least some assets directly.
You are underestimating the cost saving. For example if you are using say a ten year ladder you could save $13 per year for a $10k investment over the exorbitant fee of 0.13% charged by ITE - SPDR Barclays Intermediate Term Treasury ETF.
That's insane. $1,300 a year for an investor with a million dollars in bonds! At a 3% withdrawal rate, an investor in retirement would need to save an extra $43,000 just to pay the yearly expenses on ITE. I would be more than happy to manage my own bond ladder for $1,300 a year. :D
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Re: Bond mutual fund vs individual bonds

Post by abuss368 »

Treasuries and TIPS? Where is the income? TIPS? Next to nothing in income.

Total Bond Index and Intermediate Term Tax Exempt have worked so well.
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Re: Bond mutual fund vs individual bonds

Post by ginmqi »

berntson wrote:That's insane. $1,300 a year for an investor with a million dollars in bonds! At a 3% withdrawal rate, an investor in retirement would need to save an extra $43,000 just to pay the yearly expenses on ITE. I would be more than happy to manage my own bond ladder for $1,300 a year. :D
Good point. As a physician, I am planning to initiate a substantial savings rate (max out 401k/403b and IRA during loan repayment, then 30-40% of income during rest of career) and so the 0.10% ER will start to add up over 30-40 years. So far my IPS has a goal of 5mil of assets (in todays money) by the time I retire in 38 years.

I really thank everyone for the very insightful advice and discussion. For me, I am likely not going to invest in anything other than US govt treasuries, so no need for diversification of coporates/munis/etc. And so I may lean towards a ladder of bonds so as to save on fees as much as possible.
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Re: Bond mutual fund vs individual bonds

Post by stlutz »

OP--will you be holding these bonds in a tax-advantaged or in a taxable account? If it's the later, holding all of our bonds to maturity is sub-optimal from a tax perspective.
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Re: Bond mutual fund vs individual bonds

Post by ginmqi »

stlutz wrote:OP--will you be holding these bonds in a tax-advantaged or in a taxable account? If it's the later, holding all of our bonds to maturity is sub-optimal from a tax perspective.
I'm still deciding on that. Conventional wisdom seems to be holding bonds in a tax-advantaged vehicle. But I've come across other opinions that. Namely: http://whitecoatinvestor.com/asset-loca ... n-taxable/

I will be maxing out tax-advantaged accounts for the rest of my working career and will need a taxable account so this is the other area that I will need to look into.
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Re: Bond mutual fund vs individual bonds

Post by Doc »

ginmqi wrote:Conventional wisdom seems to be holding bonds in a tax-advantaged vehicle.
Conventionally ten year Treasuries also returned upwards of 5%.

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Re: Bond mutual fund vs individual bonds

Post by stlutz »

I actually wasn't raising the question of proper asset location (I personally replicate my asset allocation in each of my accounts).

However, if you are going hold Treasury bonds in taxable, just buying an holding a ladder until maturity ends up giving extra money to the taxman.

Suppose you buy a bond yielding 4%. A year later, rates have gone down and price has gone up. What you should do is sell that bond and replace it with another. Why? You convert interest income (taxed a higher rates) with capital gains income (taxed at a lower rate).

The net effect is small, but if we are going to worry about paying a management fee of .1%, then you need to manage every dollar of taxes as well. Otherwise, you'd still come out behind using an ETF like IEI or SCHR.

And it goes without saying that if you are going to be buying and selling these bonds, you need to do it at a broker that will let you do it for free--namely Fidelity, Vanguard, or E*Trade.
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Re: Bond mutual fund vs individual bonds

Post by Kevin M »

ginmqi, you missed a very important alternative: Federally-insured deposit accounts, including savings accounts and CDs. Currently such accounts yield significantly more than treasuries of comparable maturity, the credit risk is essentially the same, and the interest-rate risk is minimal or none for accounts opened directly with a bank or credit union.

You can get close to 1% in an online savings account. You have to go out about 3 years to get the same yield in treasuries. Specifically, a 3-year treasury yields 0.9%, while a Barclays online savings account with no interest-rate risk yields 0.9%.

A 5-year treasury yields 1.72%. A Barclays 5-year CD yields 2.25%, and has an early withdrawal penalty (EWP) of 180 days of interest. The small EWP limits the interest rate risk to a loss of about 1.125%, which is much less than the downside of the treasury.

Although decent yielding deposit accounts are not an option in a 401k/403b, they are in an IRA. In the former, you might have a stable value fund with a decent yield, but other than that, you have to choose from the available bond funds and money market funds.

Brokered CDs (purchased through a broker rather than directly from a bank or CU) also currently are available that offer higher yields than comparable treasuries, but they have similar interest-rate risk. CDs don't have the liquidity that treasuries have, so you'll probably take more of a haircut if forced to sell before maturity, but other than that, brokered CDs provide higher return for similar risk.

In a taxable account a tax-exempt bond fund might make more sense, but you should do the math to see how much after-tax yield you are gaining in return for the credit risk and much higher interest-rate risk.

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Re: Bond mutual fund vs individual bonds

Post by nedsaid »

My reactions to the Original Poster.

First, there are disagreements in philosophy about the composition of a bond portfolio. Folks like David Swenson, Larry Swedroe, and Paul Merriman have a "Treasuries only" philosophy. Rick Ferri and John Bogle are in favor of a more diversified portfolio on the bond side. I am in the latter camp, I want to be diversified on the bond side just like I am on the stock side. I want the greatest majority of the bonds in my funds to be investment grade and intermediate term. As long as you reinvest the dividends for years to come, you need not worry about rising interest rates. In other words, I am willing to take a bit of risk on the bond side.

Second, if you wanted to be absolutely safe, you could get a bit more yield by buying FDIC Insured Certificates of Deposit instead of Treasuries. These can be purchased at your bank or within a brokerage account.

Third, if you bought individual Treasuries and TIPS, you would have transaction costs if you bought them for an IRA Account or another type of investment account. You can buy these commission free directly from the Treasury at Treasury Direct but remember Treasury Direct will not act as a custodian on a retirement account. You could also buy I-Bonds at Treasury Direct as well. So if you are investing within an IRA, you have the choice of bond funds and FDIC Insured Certificates of Deposit. If you have a Brokerage IRA you could buy the Treasuries and TIPS individually but with a small commission. For workplace savings plans like the 401k's, you will likely be limited to Bond Mutual Funds.

Fourth, you buy Corporates and riskier bonds for more yield and for more return. I would use Mutual Funds for this purpose. I would NOT buy Corporate Bonds individually. Several reasons for this: call dates on the bonds, the credit rating of the company issuing the bonds can change (and usually not for the better), potentially large bid/ask spreads on the purchase of individual bonds since many are so thinly traded, and your transaction fees. If you buy Corporate Bonds individually, you become your own credit analyst. Your broker may or may not help you on determining the credit risk of the bonds. The credit rating agencies are not always right when rating the credit risk for bonds.

Fifth, I do own a couple of International Bond Funds to diversify away from the United States and to diversify away from the US Dollar. In effect, you are buying foreign currencies. Unless of course, the fund you own is currency hedged.
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Re: Bond mutual fund vs individual bonds

Post by Doc »

stlutz wrote:I actually wasn't raising the question of proper asset location (I personally replicate my asset allocation in each of my accounts).

However, if you are going hold Treasury bonds in taxable, just buying an holding a ladder until maturity ends up giving extra money to the taxman.

Suppose you buy a bond yielding 4%. A year later, rates have gone down and price has gone up. What you should do is sell that bond and replace it with another. Why? You convert interest income (taxed a higher rates) with capital gains income (taxed at a lower rate).

The net effect is small, but if we are going to worry about paying a management fee of .1%, then you need to manage every dollar of taxes as well. Otherwise, you'd still come out behind using an ETF like IEI or SCHR.

And it goes without saying that if you are going to be buying and selling these bonds, you need to do it at a broker that will let you do it for free--namely Fidelity, Vanguard, or E*Trade.
Right but the effect is not always that small. There are two different ways that can make the tax swap attractive. One you mentioned which involves a shift of the yield curve downward. The second is just the shift to shorter duration as time goes by with a constant yield curve. The second "riding the yield curve" approach is not dependent on the tax effect. Of course an active fund or even say a 1-10 fund may be doing the same thing but without the tax effect. But then its the managers choice not your own and he may not have the same perspective.

This is one of the "small" advantages that a ladder has over a fund that ogd and I were discussing previously.
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