Bond Funds: Risks and Rewards

Update: Nov 8, 2023: Beth Pinsker over at MarketWatch wrote about what to look for when buying into a bond fund. I lean in the direction of individual bonds for the reasons mentioned in Pinsker's column. For $10,000 or $25,000, there's no reason you can't buy 10 or 25 individual U.S. Treasury, GSE/Agency, or corporate bonds. When in doubt, consult a financial planner.

Back in August of 2023, I wrote about the risks of buying and owning bonds. In it, I wrote:

I'm going to focus on individual bonds here instead of bond funds. Bond funds are fine. We own shares of a couple (namely VTEB and FBND), but they're a different investment vehicle with a slightly different set of risks. I'll explain more in a future post.

Well here's that future post.

A quick refresher on bonds

A bond is a debt instrument. Governments and corporations issue bonds to raise capital for construction and business expansions. Bond holders buy these bonds and in return, the issuer agrees to make regular interest payments for a set number of years. When the bond matures, the issuer repays the face or par value of the bond, plus any remaining interest.

Bonds are usually sold in increments of $1,000.¹ That's a lot of money to wrap up in a single investment if you don't have a lot of money to invest. That's where bond funds come in.

What's a bond fund?

A bond fund is a kind of mutual fund or exchange-traded fund² that pools investor money and uses it to buy bonds. Some funds use an index strategy, buying bonds that match the Bloomberg U.S. Aggregate Bond Index (AGG). Other funds are devoted to a singular category — municipal, corporate, high-yield, or sovereign (i.e. government) debt. A few bond funds have a target date strategy, investing in debt instruments that mature in a particular year.

Bond funds distribute money to investors, based on the proportion of shares the investor owns. It's similar to the way corporations pay dividends to shareholders. These distributions come from interest payments, redemptions, and for some funds, capital gains when bonds are sold.

Advantages of bond funds

The main benefit of investing in a bond fund instead of individual bonds is this: you get more diversification for the price. In other words, you could buy a single corporate bond from a single issuer for $1,000 or you could buy a few shares of Vanguard Total Bond Market ETF or iShares Core U.S. Aggregate Bond ETF and get exposure to about 10,000 bonds (as of October, 31, 2023).

Bond funds also save you from the work of researching bonds. You don't have to sift through hundreds of issuers, monitor their credit ratings, research the issuer's financial health, and hope that it all works out. Fund managers do that work.

It's also easier to reinvest your money in a bond fund if you don't plan to use the income right away. With individual bonds, payments appear in your account. You then have to decide what to do with them. A bond with a par value of $1,000 at a 5.1% coupon rate, pays $25.50 every six months ($51 per year). That's not enough to buy another bond. In fact, at 5.1%, you'd need to invest about $20,000 to generate $1,000 in income.

That math doesn't change with a bond fund, but shares of bond funds cost much less. If your fund has an annual 5.1% yield, a $1,000 investment probably produces enough income to purchase an additional share or half of a share of the fund each year. The bond portion of your portfolio can compound in a way that it wouldn't with invidual bonds.³

Shares of bond funds are also more liquid and easier to sell, should you need the money.

Downsides

Bond funds do have their downsides, however, starting with fees. You may pay a commision when you buy or sell individual bonds⁴, but the coupon payments are all yours. Bond funds, on the other hand, withhold a percentage of returns every year to cover the costs of managing the fund. This is known as the expense ratio.

Another downside is price volatility. The price of bond fund shares fluctuates with interest rates. That means it's hard to predict how much your shares will be worth at a future date should you want or need to sell them. I bought into AGG back in 2020 and 2021 when shares were trading at $115. They're now trading at $92.20. Yes they produced income, but when I sold our shares, I sold at a loss.

The price of individual bonds also fluctuates over time. But unlike funds, you'll know know how much money you'll earn over the bond's term and how much you'll receive at maturity unless it's called or you sell it. If your strategy is to buy-and-hold, invidual bonds may make more sense.

Bond funds also have the potential for surprise year-end capital gains distributions. These gains are hard to anticipate, since you don't control whether bonds in the fund's portfolio get sold. You may end up owing a bit more in income taxes if your bond fund is in a taxable account. Individual bonds could make tax planning easier.

Which is right for you?

TL;DR: Both, maybe? We have a mix of both, with a heavy tilt towards individual treasury and government-sponsored enterprise bonds⁵. For the most part, I buy individual A through AAA rated bonds and hope for the best. If we had a financial advisor, they'd probably cringe at me for saying that. Bond defaults are relatively rare, however, particularly if you buy government and high-quality corporate bonds.

Some of the professional advice I've read suggests investing in invididual bonds only once you have hundreds of thousands to invest. When you have hundreds of thousands to invest, you get better pricing and have enough money to sufficiently diversify your holdings. Otherwise a bond fund may be the smarter approach. It's certainly the easier approach.

For bond funds that produce taxable income, consider holding them in non-taxable retirement accounts unless you plan to use the income now. In every case, choose funds with low fees — say 0.05% or lower.

Whether to invest in bonds or bond funds depends on your risk tolerance, goals, and how much money you have to invest. It's also perfectly fine to hold a mix of individual bonds and bond funds. For example, you might use bond funds for your retirement goals and individual bonds for college savings. When in doubt, consult a financial advisor.