Bond Funds for the Long Run

One of the most common investment questions people ask is, ?Should I buy individual bonds or a bond fund??

I?ll cut right to the chase. Individual bonds work well when you have a lump sum set aside for a known purpose at a known future date and you cannot afford to take any principal risk. Bond funds work well when you?re accumulating for a general purpose over the long-term and plan to distribute this money slowly in the future.

Retirement savings fall into the second category and that makes bond funds a better investment option.

Individual bonds are often used to fund large cash expenses such as college tuition, a wedding and down-payment on a house. You buy a bond or a certificate of deposit (CD) that matures close to the date the money is needed and use it to pay the bill. Investing in a high quality bond or CD makes certain your principle is there when you need it.

The disadvantages to owning individual bonds include: the time needed for research, the hidden cost of buying ?and perhaps selling ? bonds though a brokerage firm, ongoing cash reinvestment from interest and maturing securities, and a lack of portfolio diversification. Brokers are notorious for cranking in large trading spreads on small bond trades. This lowers an individual investor?s yield and crimps the resale price if a bond is not held to maturity. In addition, most individual bond accounts are under-diversified. A single default could severely damage a portfolio?s return.

That being said, individual bond portfolios work great when used for the right purpose. I laddered a zero-coupon bond Treasury bond portfolio when my children were nearing college age. The bonds matured during their university years. This strategy ensured that I had cash on hand to pay tuition as the bills came due.

A laddered bond portfolio worked great for my children?s college fund, but I?ve got a better strategy for my retirement account. I use bonds funds. They?re more practical for this long-term purpose.

First, long-term investors in bond funds participate in ?dollar-cost-averaging of sorts because money is constantly being reinvested during all phases of an interest rate cycle. Maturing bonds, interest and new money is reinvested in higher yielding securities when rates rise and the opposite occurs when rates fall. It all comes out in the wash.

Second, bond funds have a huge diversification advantage over individual bonds. The bond funds I own hold thousands of securities. There is safety in numbers when it comes to bonds. A single default in a massively diversified bond fund will not ruin my day.

One disadvantage to bond funds is that they don?t have a fixed maturity date. The fund never comes due at maturity like an individual bond. A fund?s net asset value (NAV) depends on where interest rates are on any particular day. This makes it impossible to target a guaranteed redemption value on a specific date.

This lack of a maturity date creates a red flag for some retirees because they want to know exactly what they?re going to get and when they?re going to get it. That?s why they?ll choose individual bonds over bond funds. The irony of this decision is that most people who hold individual bonds for retirement don?t spend the cash they get from maturing bonds ? they reinvest it in more bonds, just like a bond fund!

The accumulation and distribution phases in retirement last many decades and during this period the bond market will go through both rising and falling interest rate environments. Wise investors quickly learn not to time interest rates and to always be in the market. Their net return will be someplace in the middle after costs. That?s want bond funds do. So, it makes perfect sense to buy a few low-cost bond funds and be done with it.

Some advisers will recommend using both a bond ladder and bond funds in a retirement portfolio. They?ll invest a client?s money in an individual bond ladder using 1- to 10-year maturities and then put the rest in bond funds.

I don?t see the point in doing this. The strategy is more psychological than practical. The portfolio return isn?t going to be better, the risk isn?t going to be lower, and since many bond funds tend to gravitate toward a laddered strategy anyway, it?s redundant. Even bond index funds tend to be a ladder. The Vanguard Total Bond Market Index Fund (VBMFX) is a good example. Over 85 percent of the bonds in the funds come due between 1 and 10 years, with maturities staggered fairly evenly over those years.

The decision to buy bonds or invest in bond funds is linked to the purpose of the money. Individual bonds work well when a lump sum is needed at a known time in the future and principle risk is not an option. Bond funds work well when you?re accumulating or distributing money over the long-term. I like both strategies, but for retirement investing, I like bond funds more.

Visit the Bogleheads Wiki for a detailed explanation of bonds versus bond funds.

Source: http://www.rickferri.com/blog/investments/bond-funds-for-the-long-run/

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