Individual bonds vs a bond fund

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 incorrect. 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.

Diversification
Diversification is important for bonds, as it is for all asset classes. The argument against an investor ever owning individual corporate or municipal bonds (even in a ladder) is that the effect of a single default (such as a corporation or city brought down by fraud), even if unlikely, could be devastating to the investor's portfolio. By contrast, bond funds allow extremely broad diversification at a very low cost.

A ladder of individual bonds generally includes between 10 and a couple dozen bonds. That means that each bond represents 2.5% to 10% of a portfolio. By contrast Total Bond owns 3855 different bonds, and Intermediate Term Tax Exempt owns 1971. So, the failure (default) of any one bond has a minuscule effect on the fund.

The only exceptions are Treasury bonds (including TIPS). Because all Treasury bonds are explicitly backed by the US government, they have the highest possible credit rating. They also all have the same issuer. There is no diversification benefit from owning a Treasury bond fund instead of individual Treasury bonds.

Convenience
Investors in a bond fund can buy or sell additional shares at any time in any quantity. There is usually no transaction fee for buying or selling additional shares. With individual bonds, purchases on the primary market may only be made on the pre-set issuer schedule (e.g., every few months for TIPS). Purchases on the secondary market are generally subject to a commission and one always pays a bid/ask spread, which can be substantial. Also, individual bond purchases are only available in increments of $1,000 (and more often $5,000 or $10,000).

Bond funds offer automatic dividend reinvestment. While you are in your accumulation phase, it is far more convenient to have dividends automatically reinvested. Even after beginning to spend your holdings, it is generally simpler to have bond funds automatically reinvest dividends and then just sell a fixed amount of the fund monthly or quarterly. By contrast, there is no simple way to reinvest small amounts into individual bonds. It is also far more convenient to rebalance between a bond fund and other assets in your portfolio.

Taxes are simpler for bond funds. If you invest in a bond fund in a taxable account, you receive tax forms from the bond fund company. If you have a portfolio of individual bonds, you receive tax forms from TreasuryDirect or your brokerage account listing the tax-related items for each bond. It's easier to figure out the tax reporting for one bond fund versus many individual bonds. Also, owners of individual TIPS owe a tax on phantom income that they do not receive. This is not an issue with TIPS funds.

Costs
The costs associated with owning bonds are commissions, bid/ask spreads, and management fees. Primary purchases of bonds (such as at a TIPS auction) generally do not incur commissions or bid/ask spreads. Purchases and sales on a secondary market can have substantial commissions and bid/ask spreads, particularly on less liquid bonds like municipals and corporates. With the exception of primary purchases of Treasury bonds and TIPS, bond funds pay much lower bid/ask spreads on their bond transactions, giving them a significant cost advantage over regular investors purchasing individual bonds.

There is no management fee for holding a portfolio of individual bonds. However, there is an opportunity cost associated with the time to do so. If you enjoy purchasing TIPS in auction, than this time is really a consumption item rather than an expense. If tracking auction dates and the shape of the yield curve doesn't seem like fun, than it should be treated as a real cost. For example, holding $100,000 of VAIPX (Vanguard Inflation-Protected Securities Fund Admiral) costs $110 per year (with an expense ratio of 0.11%). If you value your time at $55 an hour, it is more cost effective to use this fund than hold your own portfolio of bonds if it takes you more than 2 hours a year to manage your portfolio.

Control over maturity
By managing your own portfolio of bonds, you can either pick the average duration you want or "ride" the yield curve to pick up bonds that are "cheap" compared to the  ladder overall, and allow your duration to fluctuate with your purchases. In either case, you are in control. With a bond fund, the duration is designed not to move more than a year or two and is managed by the fund.

However, investors need to consider who is in the best position to find bonds that are slightly under-priced, you or a dozen expert bond analysts at a fund company whose only job it is to follow the bond market?

Also, if you'd like a shorter duration than offered by a bond fund, it is easy to shorten it by putting a portion of the money in a money market fund. For example, the Vanguard municipal bond fund for New York has an average maturity of 11.1 years. You can approximately halve that by holding half of your money in that fund and half in the New York Tax Exempt Money Market.

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.

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.

Zero-coupon Example
Fred and Larry buy a bond fund and bond ladder, each with equal duration. Interest rates skyrocket just afterward. At that moment, Fred and Larry have an equal loss. Fred can log into Vanguard and see that his fund balance is, say, 70% of what he invested. Larry can log into Vanguard Brokerage Services and see that the total value of all of the bonds in his ladder are 70% of what he invested. Whether either decides to realize the loss or not, the loss has in fact occurred.

Now, the only difference between Fred and Larry is that Larry has two options for getting his money back and Fred has one. Fred can sell his bond fund and buy a zero coupon bond with a maturity value equal to his initial capital investment. Larry can likewise sell his bond ladder and buy a zero coupon bond. Larry's additional option is to hold all of his bonds until maturity. However, this second option is unambiguously worse for Larry. He would need to hold his longest bonds twice as long as the zero coupon bond to get his money back. Due to the opportunity cost of having his money unnecessarily locked up, this means he would actually be losing money versus the zero coupon option. In addition, for taxable accounts, selling their holdings to buy zero coupon bonds would let Larry and Fred take advantage of tax loss harvesting.

Please note that this whole example is artificial, because it is extremely rare for a bond holder to decide that he needs to immediately liquidate all of his principle. Instead, bond holders are generally interested in steady growth over the long term. Some people suffered 15 or 20% losses in their bond holdings (both fund and ladders) in late 2008. Very few sold their holdings to buy zero coupon bonds. Instead, they continued making periodic contributions like they always do, ignoring the balance of the fund. And this was certainly the right choice, as the funds have regained their previous value.

The whole argument for individual bonds being less risky is based on this completely artificial concept that you will one day decide you need all of your money back, and then happily wait 20 years to get it back (all in nominal terms, meaning the money has been eaten away by inflation in the meantime). The point of using zero coupon bonds is that they are an equally arbitrary option. But they show that Fred is never worse off than Larry: a bond fund is no riskier than a bond ladder.

In real life, people should hold bond funds (high grade, short or intermediate term, and a mix of nominal and inflation-adjusted), and just ignore the NAV. All that matters is total return, and if you hold the fund longer than the duration, your total return will be just fine. The zero coupon example is just an academic way of making that point.

These ideas were discussed on these threads:
 * How long before a bond fund will at least return principle?
 * TIPS Tip
 * For Bond Lovers
 * Bond funds vs. individual bonds

Duration
It's useful to focus on the duration of your bond fund, such as the Vanguard TIPS Fund, which currently has a duration of 5.8 years. William Bernstein provides an insightful definition of duration as the "point of indifference" for the owner of a bond fund in dealing with interest rate changes. If interest rates rise after purchasing a bond fund, the NAV of the fund falls, which hurts the investor. However, the dividends that the bond fund throws off can now be reinvested at a higher rate. The duration is the length of time that an investor needs to hold the fund for the increased yields to compensate for the decrease in NAV. In that sense, duration represents the length of time it would take for the total value of the fund, with dividends reinvested, to be worth exactly what it would have been worth had interest rates not risen. So, you should always hold bond funds with a duration shorter than the expected need for your money.

Of course, as discussed above, this definition of duration applies equally to bond funds and to an individual portfolio of bonds.

Why thinking of individual bond principal return as "safe" is misleading
The common argument for individual bonds over a fund is that at maturity you are guaranteed to get your principal back. While this is true, the principal is only one of the three sources of return for a bond:
 * 1) Principal
 * 2) Interest (coupon payments)
 * 3) Interest-on-interest (reinvested coupon payments)

According to Fabozzi in the Handbook of Fixed Income Securities, 1991, p97: "In high interest rate environments, the interest-on-interest component for long-term bonds may be as high as 70 percent of the bond's potential total dollar return."

Therefore, focusing on the principal as "safe" misses the point, since it is in many circumstances the smallest component of a bond's return. If you are saving for a large goal, you therefore have to invest considerably more into the bond than you want guaranteed to ensure the need is met by the principal.

To make sure the total value (all three components listed above) winds up being what you expected it to be, you should maintain a portfolio duration equal to your investment horizon and continually reduce the duration as your investment horizon nears (or more realistically, rebalance every 3-12 months). A zero-coupon bond does this automatically. A coupon-paying bond does not (duration declines very slowly at first and then more rapidly once the bond nears its maturity), nor does a bond fund (duration is relatively constant). Stated differently, since the duration of a coupon-paying bond is less than its maturity, if you invest such that the bond matures when you need the money, you are by definition not investing such that the duration is equal to your investment horizon, leaving you vulnerable to interest rate declines.

Convexity
Positive convexity, a characteristic possessed by bonds without options, is ignored in the above discussion but only strengthens the argument, since positive convexity lengthens duration when rates fall and shortens duration when rates rise. The Advanced Bonds section contains more detail.

Yield curve changes
Changes in the shape of the yield curve may make a difference in the above comparison, but the effect is expected to be minor and ambivalent in direction.

Rolling vs. non-rolling bond ladders
If you need to satisfy date-certain future liabilities, a non-rolling ladder of individual bonds is superior to a bond fund. For example, if you commit to make a $10,000 a year payment to a charity for five years, the most effective way to invest for that is to buy 5 zero-coupon bonds, one maturing each year. A non-rolling bond ladder has a sharply decreasing average duration, and means that interest rate shifts have no impact on your investments.

However, most bond ladders are "rolling", because they are not designed to deal with date-certain future liabilities. They are created with a specific average duration, and when the oldest bond comes due, a new long-dated bond is purchased to replace it. A rolling ladder of this kind can and should be directly compared with a bond fund using the criteria above.

As advocated by Zvi Bodie, some people aim to fund their retirement by purchasing a ladder of individual TIPS with durations of 1 to 30 years (although note that new 30 year TIPS are no longer being issued). The idea is to avoid the volatility of the underlying bonds by always holding them to maturity, so as to avoid having to sell the fund at moments when high yields have caused the NAV to drop.

If you are planning to reinvest (i.e, rollover) some of the annual redemption into new individual TIPS bonds, then you have gained nothing by using a rolling ladder over a fund. Because not rolling over the whole bond at the (hypothetically) very high yield has an identical opportunity cost to selling a portion of your fund at the (hypothetically) very low NAV. Another issue with this approach is how to deal with the longevity risk if you outlive your ladder.

Thus, the distinction between a non-rolling ladder (designed to meet date-certain future liabilities) and a rolling ladder (which essentially represents a personal bond fund) is much more important than the difference between a rolling ladder and a bond fund.

Links

 * Taxable Bond Funds and Individual Bonds Vanguard Investment Counseling and Research
 * Municipal Bond Funds and Individual Bonds Vanguard Investment Counseling and Research