Yesterday morning I awoke to an interesting article from Mike Piper over at Oblivious Investor. In it, he tackled the issue of whether you should get your bond exposure via mutual funds or through a bond ladder.
For background, a bond ladder is similar to a CD ladder, in that you buy a series of overlapping bonds with staggered maturity dates. That way you get the benefit of (typically) higher long term rates while having access to your money on an ongoing basis.
For their part, many (but not all*) bond mutual funds are a bit like perpetual bond ladders. When one bond expires, another is bought in its place — and so on, for eternity. Thus, if you buy something like the Vanguard Total Bond Market Index Fund, you’re essentially buying into a well diversified, never-ending bond ladder.
*Note: Actively managed bond funds are another beast entirely, as the managers are free to chase yields and might fundamentally change the composition of the portfolio over time.
But what if you want to draw down your bond funds over time? In this case, a bond ladder gives you far more predictability. As it turns out, the value of both bond mutual fund shares and plain old bonds fluctuate over time. When interest rates rise, the value of existing bonds fall — and when rates fall, the value of existing bonds rises.
The important point here is that, as long as you hold an individual bond to maturity (vs. selling it early), you’ll get your original investment back**. In contrast, bond funds never mature — rather, when you sell a share you’re selling a mix of newer and older bonds — so there’s a chance that you’ll have to sell when prices are down if/when you need access to your principal.
**Note: Assuming no defaults.
Other considerations include safety and convenience. I bring these up together because they’re interrelated. If you’re only interested in holding government bonds this is less of an issue, but if you’re looking for exposure to corporate bonds, too, then you’re facing a tough task. If you want to reduce the risks associated with specific companies, you’ll need to buy a large number of individual bonds.
So, in the end, the answer to the question of whether you should hold individual bonds or bond mutual funds is: it depends. As for us, we’re still in the accumulation phase and years away from needing to access our funds. Thus, we’ve been holding a broad-based bond index fund.
5 Responses to “Bond Ladders and Funds”
Just curious to ask the author as well as the readers, has anyone ever explored purchasing bonds/debt issued by smaller, privately held companies? Though they aren’t backed by the US government, or Moody’s ratings, there can be strong collateral attached, and the returns are much better.
In my opinion, for longer-time horizons, buying US government backed bonds is overkilling it on collateral. The liquidity trade off is there with privately held companies, but that’s what the illiquidity premium is for, right? Also, short term notes are issued by private companies as well.
Curious to hear thoughts.
It’s going to depend on what type of individual bonds you want to buy. For Treasury bonds (including TIPS), some brokerages (e.g., Fidelity) let you buy them at auction without any commission at all.
If you’re buying bonds from the brokerage firm though (as opposed to buying Treasuries at auction), it’s important to note that the biggest cost is often the (invisible) markup rather than the brokerage commission. Larry Swedroe had a good article for CBS News on that topic this week:
If you are buying individual bonds, what service do you recommend using to avoid paying too much in brokerage fees?
Bonds have to be a long term investment for retirement, for your family, for your children, etc. Watching the market is great but don’t burn yourself out worrying about what they are worth. When and if you ever need it, you will be happy that it’s there. That is all that matters.
Well, blow me over with a feather – I have never heard this before. It’s an excellent idea, something I’ll definitely look into.
Thanks for sharing!