Don’t Let Them Fool You—Here’s Why Bond Funds Are Not Bonds

You may have noticed a series of articles appearing throughout the year lamenting the demise of the classic 60/40 asset allocation strategy. This investment philosophy calls for portfolios to be composed of 60% stocks and 40% bonds. In theory, this asset class diversification should shield investors from the downside.

As rates have risen and the economy has stalled, there’s been no safe place to hide for investors (short of cash, which, until recently, hasn’t offered much of anything in terms of interest).

While investors may forgive stocks for their losses, the drop in bonds may have shocked them. This shock, however, may have been more acute for mutual fund bondholders as opposed to investors holding individual bonds.

There’s a good reason for that.

“Active management using individual bonds is the best way to mitigate the risk of the environment as the manager can position interest rate risk and curve position according to the environment,” says Rob Williams, Principal, Managing Director, Sage Advisory Services and Austin, Texas. “Individual bonds allow greater flexibility in structuring cash flows, and individuals do not have their cost basis and tax consequences commingled with other investors of a fund.”

It may surprise you to know this nuance—the difference between individual bonds and bond funds—is often overlooked.

“This is a fascinating detail that is not well understood by investors. When owned directly, investors can hold individual bonds to maturity,” says Gregory DiMarzio, Vice President and Portfolio Manager at Rockland Trust in Worcester, Massachusetts. “An investor has control and discretion to eliminate the effects of rising rates by holding the bond until it matures, at which time the principal is paid in full. A fund, meanwhile, because it is commingled amongst many investors, cannot do this for each investor—so those investors are left to buy and sell those funds without knowledge of the underlying maturities.”

By investing in individual bonds, you can pair specific maturity dates with your cash flow requirements. You can’t do this with bond funds. This removes much, if not all, of the downside risk, assuming the issuer of your bond doesn’t default. You can never eliminate the downside risk of a bond fund, and, depending on specific shareholder issues of that fund, the downside risk may be augmented.

“Investors can match maturities with upcoming cash needs,” says Hao Dang, Investment Strategist with Consilio Wealth Advisors in Bellevue, Washington. “A bond that hasn’t defaulted will mature at face value, so regardless of price fluctuations, owners of individual bonds will receive that value on maturity. Bond funds will need to adhere to the proxy, so if they need to sell bonds that fall outside of that proxy, they can’t be too selective. The bond market isn’t as liquid as the stock market, so selling via a fund means having to find trade partners. If the fund is experiencing outflows, this can be an issue, as the manager needs to liquidate quickly.”

Investing in individual bonds presents challenges similar to investing in individual stocks. Some bonds (i.e., those issued by the U.S. Government) may be considered virtually free of risk, but bonds issued by some municipalities as well as private companies carry greater risk. Bond funds, because they often contain hundreds of securities, can diversify this risk in ways individual investors generally cannot do.

“When an investor buys an individual bond, you are buying debt of a particular company, government, municipality, etc. that has its own unique risks including but not limited to default risk, call risk, and reinvestment risk,” says Mary Popovic, Senior Investment Analyst at Wealth Enhancement Group in Madison, Wisconsin. “When you buy a bond fund, you are purchasing a portfolio of individual bonds, which, if managed effectively, can prove to be a safer investment than individual bonds. That being said, keep in mind the inverse relationship between interest rates and bond prices. We’ve seen bond funds decrease in value because as rates increase, prices decrease, which causes the NAV to trade at lower and lower prices, causing your investment to lose value. When you buy an individual bond, you will receive the yield on the investment as long as you hold it to maturity.”

There’s another advantage that’s easier to realize if you own individual bonds rather than a bond fund. Just like stocks, you can use specific lots to manage your taxes. Still, you should seek professional advice before acting on any trading strategy.

“If you own individual bonds, you can sell a lower valued bond to harvest a tax loss and buy a new bond that pays a higher interest rate,” says Mark D. Kinsella of Family Financial Planning Services in Wheaton, Illinois. “Or you can retain your bonds and wait until the value returns to the previous value. An investor may have greater control over his interest earnings. However, if you own individual bonds, you could suffer a significant loss if any bond that you own was issued by a company that was negatively affected by the rise in the interest rate. For example, if a AAA corporation issued bonds before the rise in the interest rate; and then was forced into bankruptcy because of the higher interest rate. You may not get back the full value of the bond that you owned. Buying individual bonds can be risky. Most people do not have the skill to evaluate a corporation to determine the viability of its bonds.”

Should you forgo bond funds for individual bonds? You already know the answer.

“Depending on your financial situation, your retirement portfolio advisor may choose to invest in bond funds or individual bonds,” says Bill Lyons, CEO of Griffin Funding in Incline Village, Nevada. “Individual bonds tend to be a safer investment for retirement portfolios because you’re guaranteed to get your full principle back, capitalize on interest, and hold it until your bond matures. With bond funds, there tends to be greater risk associated with volatile interest rates. With bond funds, if the price falls, your principal investment may also decline.”

Aside from the numbers, which have been the focus of most of this article, you may find the certainty usually associated with individual bonds much more attractive than the unknown of a potential roller coaster ride a bond fund might offer.

“Individual bonds have a specified par value (amount of principal to be repaid) and a specified date of maturity,” says Herman (Tommy) Thompson, Jr., Financial Planner at Innovative Financial Group in Atlanta. “The holder of an individual bond assumes that at maturity (barring the bankruptcy of the underlying issuer), the investor will be repaid the par value. Bond mutual funds do not have a par value and are designed to be run in perpetuity. Investors in bond funds do not get the same psychological benefit that investors in an individual bond receive from knowing that their principal will be returned one day.”

Ultimately, you need to understand that a bond fund is not a bond. It is a mutual fund. And the 1940 Investment Company Act, which created mutual funds, defines these products as equities, even if they own just bonds.