Are Bonds ever better than a Fund?

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thethinker
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Are Bonds ever better than a Fund?

Post by thethinker » Sat Dec 09, 2017 12:18 am

Searching this forum, I have found many people asking questions about Bonds vs Bond Funds. Most all the answers talk about the benefits of a bond fund. Is there anything positive to be said for buying and holding individual bonds? If we can get past the diversification issue (lets say someone can invest $1million in bonds) and they only invest in muni bonds (Not 0 risk I realize but possibly a good yield with low risk), is there something to be said for holding the bond itself and being able to know the par value will be returned when the bond matures? Or is there little to know reason why individual bonds are superior to a fund?
Looking forward to the smart people on here posting below, thanks in advance.

lack_ey
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Re: Are Bonds ever better than a Fund?

Post by lack_ey » Sat Dec 09, 2017 12:39 am

Aren't there a lot of reasons given in the other threads?

There are plenty of potential benefits for at least some potential scenarios. If you manage yourself, you save on fund expenses. You can do more precise liability matching if you have known spending needs, which most generally don't. You can control when bonds are bought and sold to optimize taxes for your situation. You can create portfolios with characteristics that no fund quite has, if you're particular about certain things, such as sticking to a certain credit profile. Though as an individual this probably means sticking to highest quality issues, like AA/AAA muni bonds and the likes.

Especially for municipal bonds, you could better optimize state exposure, whether that's owning bonds for your own state (and in many, no cheap fund exists), or taking a more national profile while seeking better yields by not having to use bonds from high-state-tax states that might have lower yields (depressed from residents of that state pouring into them). If you're in a no-tax or low-tax state, in theory you could have slightly higher diversification by avoiding bonds from your own state, with the idea that your finances may at least be somewhat tied to the health of the state and the creditworthiness of many issues from within that state. That's a very marginal optimization at best but something.

In theory you could gain some slight edge investing in some less liquid bonds, if you're certain you don't need the liquidity. A bond fund wants at least a significant portion of the holdings to be liquid. That said, many of those may be lower quality, and you probably don't want those.

There's not any advantage with respect to interest rate risk, unless you need to spend some of the money in the shorter term and thus want to keep part of the money at a lower duration, in shorter bonds, where you can match things that way, though that could largely be done using multiple funds. A bond fund fluctuates because individual bonds fluctuate on the market.

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whodidntante
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Re: Are Bonds ever better than a Fund?

Post by whodidntante » Sat Dec 09, 2017 1:22 am

Treasuries and TIPS are almost [credit] riskless and very liquid. So if you have the time and like bond trading, you could roll your own treasury bond fund and it would be fine. But if you're going to go to that trouble, you might want to buy CDs instead. You'll get better return if you are any good at managing your CD stache.

Munis are far from riskless. There have been some spectacular defaults. And holding single corporate bonds is quite risky, so you need to diversify there as well.

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nisiprius
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Re: Are Bonds ever better than a Fund?

Post by nisiprius » Sat Dec 09, 2017 7:06 am

I think the answer is that it depends on your situation. There isn't a blanket answer.

An individual bond is a contract to pay specific numbers of dollars on specific dates. The bond issuer may or may not keep that contract. If the bond is rated "investment grade" (BBB or higher), then for most planning purposes we expect the contract to be kept.

A bond is better than a fund if you yourself have specific, identifiable needs for specific numbers of dollars on specific future dates, and can construct your bond portfolio accordingly. For example, although I didn't really do it very precisely, when I had individual TIPS I tried to arrange them in a rough ladder, so that during retirement every year one of them would be maturing. The idea was that I would never sell them on the market; I would let them mature, spend some, and reinvest some so as to maintain a gradually shrinking ladder. One of the reasons I moved to a fund was that I decided that I was probably kidding myself about my ability to actually carry that out, particularly given the small numbers of bonds involved.

I've certainly heard of people buying "zero coupon bonds" to pay their kids' college tuition. These are bonds--artificial derivatives built by providers from Treasury bonds that, instead of making interest payments throughout the life of the bond, they make a single payment at maturity. I doubt this is a good idea, but I just want to illustrate the point of a real-world situation where you know you will need money in (say) 2027, and you know that the bond will pay out (say) $30,474 on July 15th, 2027 whereas if you put the same money in a bond fund and let it grow you'd have $30,474 plus-or-minus. (One reason I doubt it's a good idea is that you don't actually know what college tuition will be ten years from now).

With individual bonds, in effect you are balancing these risks:

a) The risk of default, which means you don't want just one or two bonds, you want a substantial number of them.

b) The risk that you actually will need the money before the bond matures and have to sell it on the market after all. Or, generally, the risk that your planning assumptions for what dates you will need what numbers of dollars turn out to be wrong.

c) The risk that you won't have the time and energy to manage the bond portfolio properly.
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Re: Are Bonds ever better than a Fund?

Post by Call_Me_Op » Sat Dec 09, 2017 8:42 am

The only bonds I would buy as individual issues are treasuries because there is essentially zero default risk. Even with treasuries, a fund is an option but I would prefer it be an index fund.
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Phineas J. Whoopee
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Re: Are Bonds ever better than a Fund?

Post by Phineas J. Whoopee » Sun Dec 10, 2017 12:10 pm

nisiprius wrote:
Sat Dec 09, 2017 7:06 am
...
I've certainly heard of people buying "zero coupon bonds" to pay their kids' college tuition. These are bonds--artificial derivatives built by providers from Treasury bonds that, instead of making interest payments throughout the life of the bond, they make a single payment at maturity. I doubt this is a good idea, but I just want to illustrate the point of a real-world situation where you know you will need money in (say) 2027, and you know that the bond will pay out (say) $30,474 on July 15th, 2027 whereas if you put the same money in a bond fund and let it grow you'd have $30,474 plus-or-minus. (One reason I doubt it's a good idea is that you don't actually know what college tuition will be ten years from now).
...
If I may add a little detail, simple bonds like Treasuries are really contracts to pay set amounts of money on set dates in the future. All anybody reconstituting them into zeros does is sell each cash flow separately. On, for example, a $1000 face value bond earning 5% for 10 years, there are 20 individual $25 cash flows, and one $1000 cash flow.

The Treasury aids and abets using its STRIPS, Separate Trading of Registered Interest and Principal of Securities, mechanism.

It makes no difference to the Treasury who's bought the right to receive each of its individual cash obligations.

Why bother selling them? I think I posted this simile before, but it's like the local grocery store. People will pay more to get just the parts of the chicken they want than they will to buy a whole chicken.

PJW

Random Walker
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Re: Are Bonds ever better than a Fund?

Post by Random Walker » Sun Dec 10, 2017 1:28 pm

There are potentially several good reasons to choose a Muni bond ladder over a fund. A few come to my mind immediately:
1. No expense ratio
2. Tailor holdings to your own particular state tax situation
3. Can tax loss harvest at individual bond level
4. Can specifically tailor quality and maturity

Larry Swedroe has written several articles on the issue

http://www.etf.com/sections/index-inves ... nopaging=1

http://www.etf.com/sections/index-inves ... nopaging=1

https://www.advisorperspectives.com/art ... nd-ladders

Dave

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Re: Are Bonds ever better than a Fund?

Post by bondsr4me » Sun Dec 10, 2017 2:07 pm

there really is no one, clear-cut answer to this question.

it depends on each individual.

index funds are right for some....
managed mutual funds are right for others.....
individual bonds are right for others.

only you can answer this question.
i will say individual bonds require work, a level of intelligence to understand what you are doing, and more money (to achieve diversification of holdings) than using index/mutual funds.

Don

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Doc
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Re: Are Bonds ever better than a Fund?

Post by Doc » Sun Dec 10, 2017 4:12 pm

Call_Me_Op wrote:
Sat Dec 09, 2017 8:42 am
The only bonds I would buy as individual issues are treasuries because there is essentially zero default risk. Even with treasuries, a fund is an option but I would prefer it be an index fund.
Agree with only Treasuries but I would rather be in a low cost, passively managed non-index fund than be in a fund that is "locked" into buying every note that was issue in the last 5 to 10 years based on market cap at issue.

"Riding the yield" curve does have some benefit under the right yield curve conditions.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

jdb
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Re: Are Bonds ever better than a Fund?

Post by jdb » Sun Dec 10, 2017 4:52 pm

My response is only as to muni bonds, since as to TIPS prefer a ladder. I have a muni bond individual ladder built about 5 years ago, actually took a couple years to create using odd lots, got to be like a hobby using EMMA (and if you don’t know what EMMA is and how to use it should not be toying around with building a muni bond ladder by yourself), thanks Larry Swedroe for your books and postings. Also have not insubstantial allocation to Vanguard Tax Exempt Intermediate and Long Term Tax Exempt Funds (also short term fund but that is cash equivalent). In my amateur opinion the ladders and funds perform about the same, the individual bonds fluctuate in value just like funds but don’t notice as much. But think that best time to build bond ladder is when rates are relatively high so can lock in higher yield to maturity if get noncallable bonds (Thanks again Larry). But bond funds can take advantage of rising interest rates to buy higher coupon bonds over time, so would not suggest building bond ladder in today’s low interest environment since just locking in the lower rates. Just my amateur two cents. Good luck.

Random Walker
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Re: Are Bonds ever better than a Fund?

Post by Random Walker » Sun Dec 10, 2017 7:10 pm

If one has the philosophy that risk should be taken on the equity side and bonds should be as safe as possible, then a municipal ladder can have an advantage over a fund. An investor can build a ladder comprised of only the highest credit quality bonds, AAA and AA. These are generally general obligation and essential service revenue bonds. So one can have a higher average credit quality than can a fund. I believe the default rate on these highest quality municipals is just about nonexistent. Moreover if one is creating a ladder, he can use CDs for the shortest maturities. These have full FDIC protection and generally higher yields than bonds of the same maturity.

Dave

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