Bond Funds vs Individual Bonds: What's Best for Your Portfolio? (EP.223)

0:29We all need to make smart decisions with our money. when we're talking bonds is, should I own individual bonds or bond funds? Today, I'll answer that. And more importantly, I'll show you the right way to use bonds so that your overall portfolio is easier to live with through any type of market cycle. So in this episode, I'm gonna start by busting a few very persistent myths about individual bonds. I'll explain why reinvested income, not the price movements, is what drives long-term bond returns. and then I'm going to close with why I prefer non-index approaches for fixed income. The episode is designed to be evergreen, and the show notes will definitely include some charts that makes one of today's key points pop.

1:10But if you're looking for some help to sort out bonds with your investment portfolio, there's a link in the description to schedule a call with me, and I can help you get started working with PlanCorp. If you don't want to go to the episode description, that link is simply callwithpeter.com. Now, what is the role of bonds? I like to think of them as the shock absorbers of the portfolio, not the engine. Because their primary job isn't to produce the highest return or the most income, it's to reduce the overall volatility so that you can stick with your long-term plan, especially when stock markets get rough.

1:47And I think if you start with that mindset, a lot of the confusion about individual bonds versus bond funds clears up pretty quickly. Now, I want to do some myth busting just using some of the statements I commonly hear from other investors. And we're going to start with the most common, which is individual bonds are safer because I can hold them to maturity. Now, listen, holding a bond to maturity may spare you from realizing or seeing evidence of a price decline, but it doesn't spare you from the economic reality of a lower than market yield if rates move up after you buy. And while you may not see the price of your bond decline on the statement or the brokerage website, the market price is in fact different.

2:32All you have to do is try to sell the bond and you will see that yourself. Now, some people respond to that saying, well, that's why I always hold to maturity, but that ignores the opportunity cost. When you hold a bond to maturity, you have locked in yesterday's yield while the market may be offering a more attractive income today. And I think this is really where investors often misread what actually drives returns. Over a long horizon, reinvested income and compounding tend to dominate the total returns, not those short-term price movements that people worry about with their long-term bond funds.

3:09And there are two charts from Vanguard that I have in the show notes at thelongterminvestor.com that just show this beautifully. I get it. The idea of your bond funds losing money can feel scary, especially if it isn't something you're used to. But when you look at these charts and you see the real data, you have to remember that the income that you're receiving from these bonds offsets any of the price losses you may experience. And it's that income that overwhelmingly makes up the total return of your bond funds. Now, total return versus income seems to be one of these things that people struggle a lot with when they're thinking about the decision around bonds.

3:48And I covered this topic extensively earlier in the year in episode 203, Income versus Total Return. Again, I'll link to in the show notes, but you can also scroll back in your podcast app to episode 203 if you want to see that. Myth number two, pretty important because I hear financial advisors make this mistake just as much as individuals. And there's this idea, this myth that buying individual bonds avoids fees. It's true that you won't see an expense ratio on a QCIP in your brokerage account, but you are still paying a spread and a dealer markup that's just embedded into the price. And those costs are very real.

4:29They vary by issue and by size, but they're basically never transparent to the retail buyer. So with funds, the cost is visible and it's often lower than what most individuals are paying when sourcing and trading bonds on their own. Because think about it, if you're buying bonds in the hundreds of thousands, it's a big transaction. These bond funds are buying in the millions, the tens of millions, sometimes the hundreds of millions. And there's a study that I linked to in the show notes that shows that the typical odd lot retail purchase will have embedded trading costs of anywhere between 0.45 % and 0.6%.

5:06But there was a lot of data in that report that showed that number can be even higher for municipal bonds as well as some corporate issuances. So the idea that your individual bond portfolio is free is just not true. You just don't see the cost because it is embedded in the price of your bond. Third myth I want to bust here, and I hear this all the time, is that, quote, bond ladders give me more control and certainty. Ladders can feel comforting because you pick the rungs and the dates. But here's the real problem. How is this any different than a bond fund? Especially when you're just rolling the maturing bonds principle into a new bond.

5:45Because in this case, you've basically just created an undiversified bond fund for yourself that has less flexibility to reinvest efficiently across sectors and maturities as market moves, but also the interest income is likely to drag on performance because you can't really buy individual bonds with your interest payments. And what I'll often see people do is put the interest payments into a bond fund anyways. And then I get back to the point, well, what are we talking about here? This idea that you have more control, you do have more control, but that is a huge opportunity cost. And I think what is really important as we talk about these different myths is just to remember that reinvestment of yields is just such a huge driver of total returns.

6:29And a bond fund that can reinvest across thousands of bonds across the planet, they can capture more income opportunity far more effectively than a static ladder that you have to manually maintain. So just to summarize what we've done here, we've clearly stated a preference for bond funds. It's because they provide instant diversification, access to global markets, professional trading, and systematic reinvestment at current yields. And because there's access to thousands of different issuers, that also reduces the issuer specific risk and the operational headaches that come from sourcing and pricing and rolling individual bonds.

7:09So for most investors, especially those near or in retirement who value smoother outcomes, funds are the cleaner tool. I've established this preference for using bond funds instead of individual bonds, but I do have to point out something else that I see people get wrong in the space. The idea of investing in an index, because it's very different for bonds than it is for stocks. And I think that the structural issues are important enough for you to understand. Let me lay out three things. The most important one is that non-economic buyers dominate large parts of the market. And when you go out and you buy stocks, regardless of who's buying stocks, typically it's because you're trying to earn return, but more than half of global fixed income is held by participants who are not trying to maximize risk-adjusted returns.

7:59So of the global fixed income market, roughly 22 % is owned by central banks and another 32 % is owned by banks and insurers, and their mandates and constraints can distort supply and demand and pricing. And in a market that is so heavily influenced by non-economic buyers, there are opportunities for people who are profit-seeking. For those who are very big proponents of index investing, you'll be well-versed in the argument that people can't identify where there is opportunities to capitalize versus an index. So it's not these non-economic buyers alone, though. It is also the idea of how an index is constructed.

8:41So in a stock market index, the biggest companies get the biggest weight. Pretty straightforward. And that's sort of a way of the market rewarding the companies who are most in demand. But with a bond index, it's debt weighting. And that means that those who have the most debt are going to get the biggest Wait. So if you and I go into a bank seeking a loan, and let's say your balance sheet shows a$10 million net worth and mine shows that I have a$50 net worth, but I have$5 million of debt and you only have$100 ,000 worth of debt. In this scenario, the bank is going to loan me more money than you.

9:19And that is what a bond index fund is doing. And so it's just not a practical way to be accessing that asset class. The other thing, and this is going to be the last thing I mention with the bond indexes, is that there is a lot of concentration, particularly in the U.S. Aggregate Bond Index. That index in particular is heavily tilted to government and mortgage-backed securities, with treasuries being about 40%, and then the government-related MBS pushing the overall share of government exposure to about 70%. And typically, these have shown pretty high correlations, so you're not really getting as much diversification as the label aggregate implies.

9:58As a result, my preference is for non-index bond holdings. As you might guess, I have spoken in more detail on this topic before. I will link to the episode in the show notes, but it's also, for your own reference, episode 99 titled The Problem with Investing in Bond Indexes. And so if I prefer non-index bond offerings, I would say that that includes both systematic rules-based strategy or low-cost traditional active management because both can avoid the blindingly overweighting of the most indebted issuers. Both can be selective about credit and structure. Both can keep duration and sector exposures aligned with your objectives.

10:38And then most importantly, both can trade flexibly around new issuance, rebalancing, and they'll have the liquidity to harvest incremental yield. So when I talk about active fixed income or systematic rules-based fixed income, the goal is not to swing for the fences. It's really about building a more thoughtful bond sleeve that actually does the thing we need it to do, which is reduce volatility of the overall portfolio. So with that in mind, here is how I connect some of these thoughts to day-to-day decisions when it comes to building bond portfolios. If it isn't clear, and especially because I just said it, it should be, stability comes first.

11:19Bonds are there to lower portfolio volatility so that you can stay invested in equities, which really serve as that long-term growth engine. And you can do so because those bonds allow you to do it without losing sleep. And if you pay too much attention to yield rather than that primary goal of bonds, you're going to end up with riskier exposures than are necessary for this portion of your portfolio. One of the culprits today is private credit. I think that's a good example. There's a time and a place for it, but it is a very limited group of people who need exposure and it is not part of your core fixed income holdings.

11:53If something has a 9 % yield or an 11 % yield or any outsized yield, Remember that risk and return are related, and that high yield signals that this is risky. If they didn't have to pay you that much, they wouldn't, but it is so risky they have to pay you that high of a yield. So do keep in mind, stability first, yield second. The second thing I want to point out as I think about these strategies in building out a portfolio, and I didn't really mention this at any point throughout the episode, is that global exposure is very helpful. So when you diversify beyond the U.S., typically with currency-hedged global bonds, this can further smooth the ride because different economies and yield curves move on different schedules.

12:35Whether this is a global bond fund in your portfolio or using a core bond fund that gives the manager the ability to allocate globally, the purely mathematical case for global bonds is significantly stronger than the mathematical case for global stocks. So if you believe in international stocks at all, you should believe even more so in global bonds. Lastly, tax location matters. And if you're in a high tax bracket with taxable accounts, I do think that municipal bonds may be appropriate. And two weeks ago, I published a full episode on this topic that you can reference for details. Episode 221, Muni Bonds Explained.

13:15and I think that that will give you the big details within that sleeve of the bond portfolio for you to focus on. One last time, the primary role of bonds in your portfolio is not income generation or earning the highest yield, it is to lower overall volatility. But there is a right way to do it and a wrong way to do it. And if you'd like help designing a bond strategy or a complete portfolio that fits your goals and lets you sleep at night, again, I will encourage you to visit callwithpeter.com to schedule a call for me and my team at PlanCorp. As always, thanks for listening. And until next time, to long-term investing.

13:54Thanks for listening to the Long-Term Investor podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.