Is individual Bonds better than Bond Fund?

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careytilden
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Re: Is individual Bonds better than Bond Fund?

Post by careytilden »

pascalwager wrote: Fri Jun 22, 2018 11:52 am
VaR wrote: Wed Jun 20, 2018 10:50 pm
pascalwager wrote: Wed Jun 20, 2018 10:21 pm Bond funds, in the interest of convenience, encourage the investor to ignore premature redemptions and lost principle during rising rates. Individual bonds avoid this problem if the investor waits for his bonds to mature rather than selling early.

The individual investor needs to decide which is more important-–convenience or return of principle.
I don't understand what you mean. Would you please expand on this?
Yes, for example, look at the Vanguard Short-Term Bond Index Fund price history chart set at a one-year period. Would you want to be a retiree taking regular redemptions from STB while the price is steadily dropping? If instead you were waiting for individual bonds to mature, then you wouldn't be experiencing this probable loss of principle.

Discipline (waiting for maturity) is obviously required to get your money back from individual bonds in a rising rate market whereas bond fund holders in the same market seem to assume that they can efficiently sell shares thoughtlessly at any time. Isn't this disparity strange and suggestive that the two outcomes are unequal?

Now, it's possible that you would be forced to sell an individual bond early for critical living expenses, say for food or rent. That's a different matter, but at least you have the choice of not selling early for deferrable or non-critical expenses.
Superficially it makes sense that holding a bond guarantees a return on principal, but isn't this just an illusion? By holding the old bond, you're giving up the higher yield you would get by buying a new one. You can even calculate the break-even point where the new rate will make up for the loss of principal from selling the old one.
hudson
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Re: Is individual Bonds better than Bond Fund?

Post by hudson »

If you don't feel comfortable with bonds or bond funds, consider reading books and contributions by William Bernstein, Larry Swedroe, Rick Ferri, and Taylor Larimore.

https://www.bogleheads.org/wiki/Books:_ ... nd_reviews
JackoC
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Re: Is individual Bonds better than Bond Fund?

Post by JackoC »

dbr wrote: Mon Jun 18, 2018 9:56 am
1. It is entirely possible that people with a lot of money and all of it in bonds possibly should be building their own portfolio of individual bonds. I think Larry Swedroe mentions something like $200 million as a good size to do that, but I may be miss-remembering. Of course he is talking about a point where the investor is hiring professional management. Suze has a net worth "larger" than $10 million, so I am not sure she is in that class.

2. I think you are right that the real impetus to think about holding individual bonds is the mistaken idea that there is less risk. That only applies to some very specific situations that are not what most of us are talking about.
1. $200mil seems to me way too high, though depending on the type bonds. It's feasible to skip bond funds and DIY a portfolio of *treasuries* (or TIPS) at any reasonable scale (like maybe not below a few $10k total assets) with the right broker and a moderate degree of knowledge. Similarly buying CD's instead of treasuries, advantageous in many common situations (not everyone's situation, nor necessarily 100% of one's fixed income, even if some, because of the lower liquidity). The big distinction in treasury (some other US govt gteed issues) or CD's is you don't have diversify credit risk.

For bond types where you do, municipal or corporate, then it becomes a tougher issue of scale to scout out and trade in and out of a lot more issues to not have too much credit risk concentration in one issuer. But, I don't agree the scale required would be anything like $200mil, unless it's a matter of where *your* professional trader can get prices as good as Vanguard's (say) do. That's another catch there admittedly. Even if it's fairly easy to buy individual municipal or corporate issuers with a broker, that doesn't mean you're getting prices close enough to what the bond fund traders get for the worse retail prices to be offset by saving the Expense Ratio. That's an open question subject to analysis. Maybe Larry Swedroe did that analysis, but $200 mil still seems pulled out of the air to me (by him if he wrote so).

2. I agree it only applies in specific situations but I'm not sure they are necessarily that rare. It's not a big deal for bond funds of modest duration. But for long term ones there does come a point where it make less sense for a retiree to always be taking duration risk out to X years from now, as opposed to a portfolio running off over time as one's time, sadly, does gradually run out (on an expected/actuarial basis). As was mentioned back a ways, there are now funds with fixed maturity dates: this is to address a real issue. For people much earlier on in life, saving money for retirement X decades away (as opposed to a house downpayment planned for 5 yrs from now) and bond fund durations are shorter anyway, it's not necessarily an issue, I agree.

I think some of the discounting of this problem with (conventional) bond funds is recency bias of a multi-decade bond price rally, which has lasted as long as bond funds have been really common. It might be recognized better if people with a short horizon to needing their money suffer the losses on long duration bond funds in a bond bear market just before they need the money.
jsmoove123
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Re: Is individual Bonds better than Bond Fund?

Post by jsmoove123 »

careytilden wrote: Sun Sep 09, 2018 12:49 pm Superficially it makes sense that holding a bond guarantees a return on principal, but isn't this just an illusion? By holding the old bond, you're giving up the higher yield you would get by buying a new one. You can even calculate the break-even point where the new rate will make up for the loss of principal from selling the old one.
When I look at VWIUX or VCADX, I see periods of nominal losses over some admittedly short time frames (few months), whereas any Treasury bond would never have nominal losses when held to maturity. What is confusing to me is that there is no set timepoint for a bond fund - sure there is an average duration but that in no way guarantees full return of principal at any given point in time, since the holdings are laddered and refreshed. If I have an investing timeframe of 5 years and I invest in a bond fund with an average duration of 5 years, how likely am I to have an overall positive return at the 5 year mark? Is it essentially 100%? Assuming no default risk.
JackoC
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Re: Is individual Bonds better than Bond Fund?

Post by JackoC »

jsmoove123 wrote: Sun Sep 09, 2018 5:11 pm If I have an investing timeframe of 5 years and I invest in a bond fund with an average duration of 5 years, how likely am I to have an overall positive return at the 5 year mark? Is it essentially 100%? Assuming no default risk.
I think confusion on this question, both from proponents and opponents of bond funds, often comes from people making unstated assumptions about final investment horizon.

Here you are being explicit so the answer is clear. Say I plan to save up for a house down payment in 5 yrs, not open ended, uncertain and far away like potential portfolio liquidation in retirement. If I buy a 'riskless' bond fund with 5 yr average maturity or duration (the difference isn't significant for the purpose of this point) I will be subject to market moves on 5 yr bonds right up to the time I cash in the fund to make the down payment. If rates go up shortly before that, my return could be significantly less than the SEC yield of the fund now. Whether the return is positive, at least .01%, is not really the point: it could vary relatively significantly from the yield of the fund now. If I buy a 5 yr riskless bond, in the simplest case a zero coupon, duration=maturity, the return will be the yield at which I purchase it, no variation, assuming no default.

That's a real difference, albeit not necessarily an important one in other situations. Say instead I still like 5 yr duration funds/bonds but I'm retiring in 30 yrs. If I bought discrete bonds I'd be rolling them over several times anyway. This scenario seems assumed in many explanations of 'how it works', and it's probably the more common for most people most of the time. But sooner or later the (constant) maturity of a fund goes past the date when you'll actually spend the money. Then it's taking extra duration risk to use a conventional bond fund compared to buying specific bonds for that date (or one of the unusual bond funds with a fixed maturity date). Not a massive risk in the grand scheme of things necessarily, but still is.
jsmoove123
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Re: Is individual Bonds better than Bond Fund?

Post by jsmoove123 »

JackoC wrote: Sun Sep 09, 2018 9:05 pm But sooner or later the (constant) maturity of a fund goes past the date when you'll actually spend the money. Then it's taking extra duration risk to use a conventional bond fund compared to buying specific bonds for that date (or one of the unusual bond funds with a fixed maturity date). Not a massive risk in the grand scheme of things necessarily, but still is.
Thanks, that makes sense. Is it correct to assume also that for an accumulation-phase investor saving for retirement 20 years later, the return on a 5 year duration bond fund would trend toward its SEC yield over that period of time (like its moving average) given that there will be numerous rollover events in that time frame? Or do you still have to further take into account what interest rates have done to its share price/NAV in that 20 year period?
pascalwager
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Re: Is individual Bonds better than Bond Fund?

Post by pascalwager »

careytilden wrote: Sun Sep 09, 2018 12:49 pm
pascalwager wrote: Fri Jun 22, 2018 11:52 am
VaR wrote: Wed Jun 20, 2018 10:50 pm
pascalwager wrote: Wed Jun 20, 2018 10:21 pm Bond funds, in the interest of convenience, encourage the investor to ignore premature redemptions and lost principle during rising rates. Individual bonds avoid this problem if the investor waits for his bonds to mature rather than selling early.

The individual investor needs to decide which is more important-–convenience or return of principle.
I don't understand what you mean. Would you please expand on this?
Yes, for example, look at the Vanguard Short-Term Bond Index Fund price history chart set at a one-year period. Would you want to be a retiree taking regular redemptions from STB while the price is steadily dropping? If instead you were waiting for individual bonds to mature, then you wouldn't be experiencing this probable loss of principle.

Discipline (waiting for maturity) is obviously required to get your money back from individual bonds in a rising rate market whereas bond fund holders in the same market seem to assume that they can efficiently sell shares thoughtlessly at any time. Isn't this disparity strange and suggestive that the two outcomes are unequal?

Now, it's possible that you would be forced to sell an individual bond early for critical living expenses, say for food or rent. That's a different matter, but at least you have the choice of not selling early for deferrable or non-critical expenses.
Superficially it makes sense that holding a bond guarantees a return on principal, but isn't this just an illusion? By holding the old bond, you're giving up the higher yield you would get by buying a new one. You can even calculate the break-even point where the new rate will make up for the loss of principal from selling the old one.
But the new bond would need to match the remaining term on the old bond. Since it would be shorter term than the original bond, the yield might be less than you're assuming. And some investing websites clearly state that you're not assured of getting your principal back when you take redemptions from bond funds. I assume advisors know this but consider it acceptable when compared to even greater potential for loss from equities.
Nightowl99
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Re: Is individual Bonds better than Bond Fund?

Post by Nightowl99 »

Before I started reading advice from the Bogleheads about simplifying, I decided to make up my own little five-year bond ladder, a mix of CDs and treasuries, just to see what would happen. The average interest rate of that particular bond ladder turns out to be 2.65%. So, today I can compare that to the Total Bond Market fund avg. annual fee-adjusted return of 2.4%, for the past five years. I realize this is an apples to oranges comparison, but the difference could possibly be explained by the expense rato (.05 x 5 years = .25?). Or maybe I'm looking at this too simplistically.

Anyway, now the bond fund's doing better than the much smaller bond ladder; its SEC yield for the prior 30 days is 3.13%. By holding onto the bond ladder, I'm losing out on a little interest. Still, if I hold the treasuries and CDs until they mature, there won't be any loss of principal, while the bond fund, if sold now, would appear to be a capital loss due to a decline in the price per share. Over time, though, if interest rates continue to rise, the bond fund may come out ahead because it's continuing to buy newer bonds that are earning more interest. At least that's my hope, because I have a lot more invested in the bond fund....
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Kevin8696
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Re: Is individual Bonds better than Bond Fund?

Post by Kevin8696 »

Nightowl99 wrote: Mon Sep 10, 2018 10:52 pm Before I started reading advice from the Bogleheads about simplifying, I decided to make up my own little five-year bond ladder, a mix of CDs and treasuries, just to see what would happen. The average interest rate of that particular bond ladder turns out to be 2.65%. So, today I can compare that to the Total Bond Market fund avg. annual fee-adjusted return of 2.4%, for the past five years. I realize this is an apples to oranges comparison, but the difference could possibly be explained by the expense rato (.05 x 5 years = .25?). Or maybe I'm looking at this too simplistically.

Anyway, now the bond fund's doing better than the much smaller bond ladder; its SEC yield for the prior 30 days is 3.13%. By holding onto the bond ladder, I'm losing out on a little interest. Still, if I hold the treasuries and CDs until they mature, there won't be any loss of principal, while the bond fund, if sold now, would appear to be a capital loss due to a decline in the price per share. Over time, though, if interest rates continue to rise, the bond fund may come out ahead because it's continuing to buy newer bonds that are earning more interest. At least that's my hope, because I have a lot more invested in the bond fund....
Maybe I can shed some light by identifying some of the shortcomings in your analysis, and offering some ideas.

First of all.... Portfolio differences. Comparing a 5-yr laddered portfolio of CD's and treasuries to Total Bond Market Fund's (VBTLX) portfolio is an apples to bananas comparison. The VBTLX portfolio has a much different mix of issuers and maturities over a broad spectrum of credit qualities; and is comprised about 47% government, 27% corporates, and 25% mortgage-backed securities (largely residential). The average effective maturity of VBTLX is 8.4-yrs, with a portfolio duration of 6.1-yrs.... compared to your 5-yr ladder of CD's and treasuries.

Second item... Differing time periods. (a) Comparing the current rates/yields of your present 5-yr CD/Treasury ladder to the past 5-yrs of VBTLX is not a valid comparison for lots and lots of reasons. Your comparison should cover the same time period for both the ladder and the fund, not two sequential 5-yr periods. Apples to blueberries.

Third item.... Expense Ratio. The average annual return of 2.40% for VBTLX includes expenses of 0.05% embedded in that total return figure. You can't de-average this by multiplying 0.05% by 5 yrs, unless you multiply the average annual return by 5 yrs as well. Apples to cantelopes.

Fourth item... Rates vs Yields. You said the interest rate on your CD/Treasury ladder is 2.65%. Is that the coupon rate of interest, or yield-to-maturity, or ??? Did you buy the treasuries at par, or a discount, or a premium ? Regarding the SEC yield... to be clear, the SEC yield is NOT the historical return of the bond fund over the past 30 days. It is forward looking, and is calculated using the yield-to-maturity over the past 30 days of all the bonds in the portfolio. The 3.13% figure you see is hypothetical in nature, since it assumes that bond prices will not change... and we know how that's going these days. People like to jump on the SEC yield for comparisons, but it's not always the best metric. Apples to apple sauce.

Recommendation: If you are looking to compare your CD/Treasury bond ladder to a bond fund, I would suggest looking at the Vanguard Short-term Treasury Fund (VFISX). Quick look at that fund.... Portfolio is all treasury and gov't agency securities. Average effective maturity is 2.2 yrs, average duration is 2.2 yrs, average coupon is 1.6%, average yield-to-maturity is 2.8%, and the SEC yield is 2.41%.

In your analysis, please keep in mind the effects of "cash drag"... in that it can be very difficult to reinvest the bond interest payments received at an equivalent yield as the laddered portfolio. Also, consider that bond funds mark their assets to market every day... so when market yields go up, the value of your fixed rate CD's and Treasuries will go down, just like the bonds in the bond fund.
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