Talk:Individual bonds vs a bond fund

Good start. I inserted some comments in the page. In general I think it could benefit from a more tutorial style, more links to terms, and more back-up for assertions. I apologize for not fixing all this myself right now. I did a bit and commented on the rest. --Sewall 12:25, 1 April 2009 (UTC)

sewall, please don't create dangling links, as they make the wiki seem broken. If you want to create a definitional page like primary and secondary markets, please add the links to it after you create the page. Also, please make comments to other users on this page, rather than in the article. Thanks. Dan Kohn 15:09, 1 April 2009 (UTC)


 * Dan, it is not necessary to have a public conversation about our stylistic differences. Please revert the page if you don't like how I edited it. --Sewall 16:21, 1 April 2009 (UTC)

Forum discussion related to this page: Bond fund versus individual bonds, definitive answer --LadyGeek 16:07, 24 January 2010 (UTC)

References to the controversial aspects of this page are due to the assumptions used. There may not be a way to resolve the controversy, see this post: Bond fund versus individual bonds, definitive answer --LadyGeek 18:12, 7 March 2010 (UTC)
 * There is contention because people are basically arguing about different things and there's no one-size-fits-all solution. ...
 * It is appropriate for a Wiki to explain how things work. In most cases I don't think a Wiki is a place to formulate "plug-in" advice for the individual case.

I added an excerpt from "The Bond Book" (It is ok since this it is for educational non-profit use See Fair Use). I also replaced the statements to the effect that "bonds funds and individual bonds are identical" with words to the effect that "they can be similar." They do not behave identically unless the holdings are identical. I took out the example with TIPS because it was confusing to all but the people who already understand the issue. --RobG 3 September 2010

In the opening statements I'd like to change "... less risky than a bond fund, but this is incorrect." to "... less risky than a bond fund, but this is not necessarily true if the proper bond fund is chosen." However, I can't figure out how to do this. RobG

The beginning of that sentence contained a broken link, but the wiki didn't show the error (red). The missing link is present the revision as of 16:16, 24 January 2010 (look in the history tab):

== Bond funds are no riskier than individual bonds ==

It has been regularly argued on the Bogleheads forum that a bond fund is risky because of NAV fluctuations. For example, the NAV for Vanguard Inflation Protected Securities fell 20.4% from peak to trough in 2008. Instead, it is said, investors should hold individual bonds, which can always be redeemed at face value by holding until maturity.

This argument is wrong because the individual bonds in a bond fund react to the market identically to the individual bonds held in a personal portfolio. You can see this by manually calculating a NAV for your own portfolio of individual bonds, and watching its daily fluctuations. The key thought is that although bond funds do have volatility, they are exactly as volatile as a rolling bond ladder with the same duration. On a Bogleheads Forum post, tfb made this explicit with the following example:

"After you create your TIPS ladder, call this ladder 'My TIPS Fund.' Create some imaginary shares and calculate the NAV for your fund. When one bond matures, for which you receive the full guaranteed value and real yield, you take the cash, divide by the NAV at that time, and reduce the number of shares you still own in My TIPS Fund. Now, it's as if you just sold some shares from My TIPS Fund at the current NAV. Let's say the NAV is lower than the initial NAV. Did you just suffer a loss? Or did you receive the full guaranteed value and real yield from the matured bond? You see it's just a matter of framing. The substance remains exactly the same."

At any moment after buying a bond fund, you can always be assured of getting your principal back. Just as when holding an individual bond, you may have to wait some period of time if you want to be reassured the return of your principal. That period of time is the duration. Since you should always have been keeping your duration equal to or less than your investment horizon (the time after which you need the money), you will be indifferent to (if the duration equals your horizon) or happy about (if the duration is less than your horizon) interest rate increases which cause a decline in NAV. In fact, you will be slightly better off if yields change and your fund has positive convexity, as is the case with most non- MBS funds.

If you have a sudden need to extract the principal from a bond fund (or portfolio of individually-held bonds, for that matter), you can do so as rapidly as possible by selling the fund and buying a zero-coupon bond with the face value of your principal. Such a bond will always be available, because if the fund's NAV is down, yields will have gone up a commensurate amount. On average (with a typical yield curve), the bond will have a maturity equal to the duration of the TIPS fund. (A regular TIPS bond would also serve the same purpose, but a zero coupon bond makes the calculation simpler, because the duration equals the maturity.)

The strategy of buying a zero-coupon bond works because the duration of a zero equals the maturity, and therefore declines steadily as time passes. No other commonly-available type of bond instrument has this property (although it can be replicated with bond funds or with individual bonds, provided you rebalance regularly). Therefore, if you have a fixed, known obligation at some future point in time, a zero-coupon bond is the obvious choice to satisfy it.

I made RobG's update and changed the link to point to "Why thinking of individual bond principal return as "safe" is misleading". Did I change the intent of the statement? Should the link be removed? --LadyGeek 19:48, 3 September 2010 (UTC)

First of all, thanks to RobG for undertaking edits which clearly took a lot of time and thought, and strengthened the page. I have tried to go back through and work in the Thau quotes in a way which remains consistent with the original framework of the page (a comparison of a rolling ladder), while expanding it to include Thau's perspective (which largely pertains to non-rolling ladders). I have also tried to break up the massive block quote from Thau with commentary in between and in so doing have trimmed the quotes a bit to make it more streamlined while still saying fundamentally the same thing.

The major substantive edit to the Thau quotes was removing the comment about fluctuations in NAV due to changes other than those in interest rates (credit quality, exchange rates...). I started to write an explanation of how those factors also affect individual bonds (just because you decide not to mark your AIG bond to market the day after the financial crisis hits doesn't mean that your expected payout on that bond hasn't declined; actually favors bond funds because of diversification, etc.), but it became too large a digression. Therefore I removed that sentence and left her statements about the NAV of a bond fund changing due to interest rate changes alone (which is everyone's worry with bond funds anyway).

TODO:
 * Make the rolling/non-rolling bond ladder links go to a separate wiki page which describes how to set them up (i.e. a description of what each is), rather than how to compare them.
 * The "Why would you choose a declining duration portfolio/fund?" section is a little anemic and could use more fleshing out.

--Linuxizer 13:54, 4 September 2010 (UTC)

I removed the "Controversial" flag as the focus of this page totally changed, making prior discussions obsolete. From tfb: There is contention because people are basically arguing about different things and there's no one-size-fits-all solution.

Pro fund: A rolling ladder is a fund. Pro ladder: A fund does not reduce its duration as time goes by.

Both points are true. Trying to simulate a ladder with funds is clumsy. Trying to simulate a fund with individual bonds is next to impossible unless we limit to Treasurys.

Therefore the contention can be solved only if we don't see it as either/or. Use the right tool when the job calls for it. I think the page rewrite clearly shows "how to use the right tool when the job calls for it".

--LadyGeek 18:15, 4 September 2010 (UTC)

Thanks LG. I noted before but I want to emphasize that to really show "how to use the right tool when the job calls for it," or more specifically the latter part of that, we need to flesh out the "when to use which" section more. --Linuxizer 20:09, 4 September 2010 (UTC)

Linuxer -- I think chopping Thau's work up made it a lot more confusing and would prefer that you undo it. Thau's work, when presented by itself, gives a good background to the subject and highlights the issues. From there it makes sense (IMO) to explain how the two investment types can have similar risks even though they are radically different. There is no contradiction... they are different investments and if caution is not used they will give vastly different results.

As it is, you send the reader on all sorts of diversion before the problem is even presented and cover stuff that is explained in following sections. --RG

Hi Rob,

I feel pretty strongly that block-quoting Thau didn't make the article more clear. I think that the central problem is that she is talking about one thing (a single, individual bond with a fixed nominal investment horizon--fairly similar to a non-rolling ladder), and the wiki page even before your edit took great pains to differentiate between that situation and a rolling bond ladder. If Thau has quotes comparing rolling bond ladders to bond funds, that would be extremely helpful. The example you quoted does not do that, and so--while it is nice and can be integrated into the page--dropping it in without any context or explanation is not appropriate neither from a wiki stylistic perspective which favors user-generated content nor from a explanatory perspective, where readers do not have the context of the entire book to figure out that she is speaking of a very specific situation.

Since your PM to me was essentially the same as what you put on this page, minus the following quote, I have added it here. I'm happy to talk by PM as well, but I think that talking here or in the forum will be more productive since it will bring out others' opinions. "I also see that you are starting to put in implications that bond funds are equivalent to a rolling ladder. Please stop. Bond funds are managed in so many ways that that statement obviously can't be true in general. In addition, it is the exception, not the rule, that bond funds are operated as rolling ladders: as Thau explains, they generally focus around a specific maturity date +/- a few years." I believe you have confused a rolling ladder with a non-rolling ladder here. As Thau explains, almost all funds focus around a specific maturity date, making the equivalent comparison a colling bond ladder. The plus/minus drift is fairly inconsequential and tends to be very smooth. To the extent that any drift occurs, that phenomenon is covered in the section under manager risk. If it is the word "equivalent" that you are objecting to, please feel to change it to something more akin to your own wording, "have similar risks" (and, I would add, not only similar risks but nearly identical risks, such that they perform nearly identically). To me, it's distinction without a difference, but I'm happy to support alternative wordings as long as they are accurate.

If you want to attempt to integrate the quote in a different way, I'm certainly open to it. As it was, I thought your dropping the quote in was helpful but desperately in need of integration and then a transition with the larger page, which I attempted to provide. I think the key distinction will fundamentally be the same, and I don't think we disagree here: a declining duration instrument like a non-rolling ladder or (as Thau discusses) individual bond is not an appropriate comparison to a bond fund. A constant duration instrument like most bond funds or rolling ladders, is. --Linuxizer 18:05, 7 September 2010 (UTC)

Linuxer -- thank you for your diagnosis but I am not confused about those things. Note that this wiki is entitled "Individual Bonds vs a Bond Fund." The material I quoted came from a book section entitled "What are some of the major differences between individual bonds and bond funds?" That is an exact match. Furthermore, the material I quoted came from Thau's definitive book on the subject of bonds, which you don't seem to be familiar with. Furthermore, the quoted material was used as part of the introduction to a 42 page chapter on the '''pros and cons of bond funds compared to ind. bonds.''' If Thau thought retitling her section "an apparent contradiction" and inserting a tangential explanation in which buying an iPad with the coupons is explored, I'm sure she would have written it that way. Instead she pointed out the major differences in the opening and then in subsequent section she described the pros and cons of each choice. The readers of this wiki would be well served if we would follow her lead and do the same.

Since the quoted material outlined the undisputed differences between ind. bonds and funds, it provided an excellent springboard for a discussion on how rolling ladders have characteristics more in line with SOME bond funds. I request again that you revert the section back to the way I had it and address any issues you have with her facts afterwords, citing the appropriate authoritative references. --RobG1 8 September 2010

Perhaps one solution to this dilemma would be to place the Thau quote into a quote box and then provide discussion with reference to the quote. Here is "look" at the page as it formats with the quote box (I am including enough headers to generate a TOC).

The major factors  in deciding between owning a bond fund versus individual bonds are:  diversification,  convenience,  costs, and  control over maturity. There is a common belief (promoted by Suze Orman, among others) that owning individual bonds is less risky than a bond fund, but this is not necessarily true if an appropriate bond fund or collection of funds is chosen. Duration is an essential attribute for understanding the riskiness of a fund or ladder over time. There's also an important distinction between owning a ladder of individual bonds designed to meet specific future liabilities, and holding a rolling bond ladder.

The interest-on-interest dilemma
To see why interest-on-interest is not predictable, consider your situation as an individual investor who has just purchased a five-year bond. Six months in, your bond pays its first coupon. Excited, you run to the mailbox and pick up the check. But now you have a dilemma: what to do with your newfound riches? You could buy that shiny new iPad you've been craving, true, but this was investment money--money that you either had socked away for 5 years from now when the bond matures or (more likely) for an indefinite period in the future, such as retirement. Moreover, if you don't reinvest the interest, you won't get the full annualized yield that made you so excited to buy the bond in the first place. So you decide to reinvest the coupon payment.

Your next decision is where to put the money. You can place it in a bank account, true, but extremely liquid riskless investments like bank accounts generally pay considerably less than investments where you have committed to locking up the money for some time in the future, like bonds or CDs. If you buy a bond/CD, you have another decision to make. Do you want to buy another 5-year bond? In doing so you will have constructed not the non-rolling ladder of our current scenario but rather a rolling ladder which we will discuss further down the page. Or do you want to buy a 4.5-year bond (and, with the next coupon payment, a 4 year bond, then a 3.5, then a 3, etc. etc.)? Then you will have constructed a non-rolling ladder, with the bonds purchased with the coupon payments yielding less and less as time goes by because their maturities are shorter and shorter.

Whatever you decide to do with the coupon payment, the interest you receive on the coupon interest (the "interest-on-interest") is uncertain. If you put the coupon money in a bank account, the interest rate varies every day. If you put the coupon money in a bond, because the date you are buying a bond is not the same as the date you bought the main bond, you are subject to current market rates

NAV fluctuations
Thau continues: ''Bond funds are comprised of a great many issues. While a number of individual issues may remain in the portfolio until they mature, there is no single date at which the entire portfolio of the fund will mature. In fact, most bond funds maintain a “constant” maturity. For example, the maturity of a long-term bond fund will always remain long term, somewhere between 15 and 25 years. The maturity of a short term bond fund, on the other hand, will always be short, that is, somewhere between one and three years. Consequently, unlike an individual bond, the NAV of a fund does not automatically return to par on a specified date.''

''As a result, the price at which you will be able to sell shares of a bond fund cannot be known ahead of time. It will be determined by conditions prevailing in that sector of the bond market when you sell your fund.''

She goes on to say:

''Another way of looking at this difference is that, if you own an individual bond, each year its market value (its price) moves one year closer to par. But because it has a constant maturity the NAV of a bond fund follows interest rates. For that reason, its future is not predictable.''

''Because the price of a bond fund does not return to par at a specified maturity date, it cannot quote a yield-to-maturity. As a result, any comparison between the potential return of an individual bond and a bond fund is imprecise. You are comparing apples to oranges.''

This is not to say that a proper bond fund can’t be used to achieve the same goal as a portfolio of individual bonds with approximately the same risk. The key is Thau's statement that future returns, given constant maturity (more precisely, constant duration) are unknowable, whereas with a declining maturity they can be reasonably well-predicted.

Methods of achieving declining vs. constant duration
What kinds of tools produce a declining duration?
 * An individual bond, with coupons reinvested in some form that is liquid on the bond's date of maturity (e.g. a bank account, bonds with shorter and shorter maturities as described above, or CDs with put options)
 * A Zero-coupon_bond, which doesn't pay out a coupon so that no reinvesting of coupons is required.
 * A portfolio of individual bonds, purchased with shorter and shorter maturities. A.k.a. a non-rolling bond ladder
 * A target-date bond fund. These are rare funds and tend to have very high expense ratios.  We will therefore not consider them further.

What kinds of tools produce a constant duration?
 * A portfolio of individual bonds, set up such that when one bond matures another bond of equal maturity is purchased. A.k.a. a  rolling bond ladder.
 * A bond fund, where a manager maintains the portfolio to have a fairly constant duration.

Reasons for choosing declining or constant duration
Assuming the hassles and expenses associated with each were about the same...

Why would you choose a declining duration portfolio/fund?
 * You have a known expense at a future date that you want to set money aside for. Examples include saving for a car, or for some investors, college.

Why would you choose a constant duration portfolio/fund?
 * You are saving for expenses with unknown amounts and/or unknown time horizons. Examples include retirement, saving for a house down payment, or for some investors, college.--Blbarnitz 16:33, 8 September 2010 (UTC)

I think the flow of information is very disjointed in your example. On the other hand, a flow where Thau's intro is first, followed by the "framework..." and rolling bond, etc sections would flow logically: I.e., the physical differences between Bonds and Bond funds -> How we use bonds in a portfolio -> Rolling ladders have similar characteristics as bond funds (NAV fluctuations, interest rate risk, etc). I actually think the section "why thinking ind.bonds are safe is misleading" would go best before jumping into ladders etc. In other words, the overall picture needs to be presented logically before the details are expanded on. --RobG1 8 September 2010

I am starting to think it would be better to have a separate wiki for the topic of "rolling ladders vs bond funds." --RobG1 8 September 2010


 * Rob: The quote box example is simply a format example (the quote box is the default venue for placing relatively large direct quotes into the wiki). A more appropriate stylistic solution for including the Thau concepts into the body of the wiki would be to summarize the main points of her argument (referenced to her book), with, as you suggest, ensuing sections providing a logical flow in examining the issues raised. --Blbarnitz 20:00, 8 September 2010 (UTC)

--- Hi Rob, I'm a bit frustrated at this point because I feel like I am making substantive arguments (for instance, that an individual bond, as Thau uses as her framework, has a declining maturity/duration, wheras this page was conceived to compare apples to apples, that is non-declining/"rolling" bonds to non-declining funds), and getting back appeals to authority. Thau is an excellent source, but she is clearly talking about one thing and this page has addressed that thing. It's not that she's wrong, it's that she's using an entirely different framework. I'm reasonably certain if we could contact Thau she would agree that this is merely an alternative framework and a good one, and neither contradicts the other. If any of us have her contact info, I am happy to contact her myself.

At any rate, I am not opposed to splitting it into two pages, a pro and a con. Alternatively, Barry has made an attempt at re-organizing the page, and I'm happy to see where that goes as well.

I should add that, despite implications to the contrary, I am in no way a pro-fund zealot. Nearly every anti-fund argument on this page (and at this point there are quite a few), including the summary recommendations against funds for Treasuries, was added by me.

Thanks, --Linuxizer 13:14, 9 September 2010 (UTC)