Question of Interest

BONDS MAY NOT BE the most interesting investment, but they generate their fair share of debate. Especially after 2022’s rout, when total-bond market funds dropped 13%, many investors wonder how best to proceed. An open question: Does it make more sense to buy individual bonds or opt for bond funds?

To answer this question, let’s start with a simple example. Suppose you’d invested in Vanguard Group’s total-bond market fund (symbol: BND) on Jan. 1, 2022. As of today—two and a half years later—that investment would still be down more than 5%, even including the interest income received along the way.

It’s because of depressing results like this that many investors argue in favor of individual bonds. Because bond issuers promise to repay investors in full when they hold a bond to maturity, buying individual bonds seems like a no-lose proposition and an easy way to avoid the losses inflicted on bond fund investors.

This, however, isn’t an apples-to-apples comparison. Suppose that on Jan. 1, 2022, you’d purchased a collection of bonds that mirrored the holdings of the bond fund described above. It’s true that, if you held all of those bonds to maturity, you’d indeed avoid losses. But that’s not the right comparison, because it overlooks the value of those individual bonds today. If you tried to sell them today, you’d realize a loss in the neighborhood of 5%, matching the cumulative loss in a comparable fund.

In other words, there’s no mathematical difference between a bond fund and a collection of individual bonds that matches the holdings of that fund. It’s only when bonds are held to maturity that they can help investors avoid losses.

Like everything in personal finance, though, there are caveats. For starters, bond funds—like all funds—carry costs. But bond fund fees tend to be modest, so I don’t see this as a significant factor. And because the bond market, unlike the stock market, doesn’t operate with quoted prices, there can be significant trading costs when buying individual bonds. Bond fund managers, with their dedicated trading teams, will generally do better than individual investors. That arguably can offset a fund’s fees and thus I wouldn’t let cost be a deciding factor.

A more important issue is the risk inherent in any mutual fund. Being an investor in a fund is like being a passenger on an elevator with other people. Everything ought to be fine—as long as everyone else behaves. It’s the same in a mutual fund. Your fate, to a degree, is dependent on your fellow shareholders.

That’s because, when a fund is having a challenging year, some investors will head for the exits. That can force the fund’s manager to sell part of the fund’s assets at depressed prices, locking in losses. That loss is then shared pro-rata among all fund investors. With a portfolio of individual bonds, you don’t face that risk. You have the ability to hold on through tough patches and avoid locking in losses.

Individual bonds carry other benefits. Key among them is the ability to lock in current interest rates. With today’s rates at levels that we haven’t seen in more than 15 years, this is a valuable opportunity. You could build a ladder of bonds going out 10 years and lock in rates in the 4% to 5% range. It would be difficult to achieve this level of precision with a bond fund or combination of funds.

Another way in which individual bonds can be beneficial: Suppose you’re in retirement and withdraw $50,000 per year from your portfolio. A ladder of $50,000 bonds maturing over the next five to 10 years can simplify portfolio management. Each year, you’d simply withdraw the proceeds of the maturing bond. While less common for individual investors, this is a bedrock strategy employed by insurance companies to ensure they always have the funds for future claims. In fact, it’s a key reason many insurance companies have been in business for 100 years or more, so it has a lot of merit.

At the same time, funds offer benefits of their own. At the top of the list is simplicity. Because the bond market is so much larger and more diverse than the stock market, buying bonds takes work. Depending on the type of portfolio you want to construct, it can also be difficult to achieve sufficient diversification. And if you build a ladder, it will require further time and effort to reinvest the proceeds as bonds mature.

So, does it make more sense to buy individual bonds or opt for bond funds? I favor a hybrid approach.

I’d include a mix of short- and intermediate-term maturities. That’s because short-term bonds offer greater stability when interest rates rise, while intermediate-term bonds provide greater appreciation potential when rates drop. What about long-term bonds? This is a corner of the bond market that I wouldn’t include, because of its volatility.

For exposure to short-term bonds, I’d opt for funds, owing to their simplicity and liquidity. Which funds? Because they’re backed by the U.S. government, my first choice would be U.S. Treasurys. If you’re in a high tax bracket, you might also include some municipal bonds.

For intermediate-term exposure, I recommend a mix of bond funds and individual bonds. That’s because funds offer simplicity—they’re easy to buy and sell for withdrawals or rebalancing. But only individual bonds offer the ability to lock in rates, as described above, and this could be a great benefit when interest rates drop, which will likely soon happen, or so the Federal Reserve recently telegraphed.

What else might you include in a bond portfolio? I’d own some inflation-protected bonds, such as Treasury Inflation-Protected Securities (TIPS). According to research by Vanguard, short-term TIPS are the most effective type of bond to guard against inflation, so that’s what I recommend.

Among the thousands of bond funds available, which should you choose? Just like with stocks, I tend to prefer index funds. This is an area, though, where there’s a significant difference between stocks and bonds.

The data tell us most actively managed stock funds lag their benchmarks. But it’s a different story in the world of bonds. According to a recent survey conducted by research firm Morningstar, nearly three-quarters of actively managed bond funds beat their benchmarks over the past year, so I wouldn’t necessarily exclude an actively managed fund from consideration.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam's Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.

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