Individual bonds versus bond funds.
This blog post will look at why investing in bond funds can be more “risky” than an individual bond portfolio.
Individual Bond portfolio – purchasing a wide selection of individual bonds in the primary bond market, typically held to maturity (or maybe with some judicious sales along the way if the price in the secondary bond market is right). An individual bond portfolio has some default risk for each bond, so should be diversified across multiple bond holdings to reduce this default risk. The risk on the stability of bond prices in the secondary bond market can be mitigated by holding to expiration. A individual bond portfolio can be harder to re-invest coupon payments (especially in lower interest rate environments), because typically bond purchase minimums can be in the $1k or $10k range.
Bond Funds – this is a collection of bond bought (and sold) at different times based on the fund investment remit (e.g. government, munis, corporates etc). A bond fund is really a bet that the bond prices in the secondary market will decrease less than the yield received. But another way, this is a bet on the stability or increase of overall bond prices in the secondary market over a period of time (from buy to sell transaction). A bond fund makes it easier to re-invest small amounts (e.g. re-invest coupon payments) because they can typically be bought as if they were a stock or ETF. Bond funds also have expense ratios that can reduce returns each year (typically in the range of 0.5% upwards).
Obviously both individual bond portfolio and bond fund approaches generate yield (collect coupon payments). The major difference between the two approaches is the risk of movement in secondary bond market prices.
This very simple example compares two approach purely to isolate price risk:
1) “Individual Bond” – Buy $10k worth of 20 year US government debt
2) “Bond Fund” – Buy 80 shares of TLT stock at $125 costing $10k – invests in the 20 year US government
Disclaimer: Fixed income pricing is very complex and many factors go into it.
Example assumptions :
- that the starting yield (on initial purchase) will be the same on both products.
- dividends are not reinvested (this can greatly improve returns)
- transaction costs are ignored
- inflation risks are ignored, example only considers nominal price
- long term higher yields will mostly affect long term bond pricing (not the current investment climate where the “market risk premium” or qualitative easing (QE) government policy are affecting bond prices)
- not to state what WILL happen, just what COULD happen if rates rise.
- US government still exists as a functioning entity! (i.e. assume that return of principal is guaranteed)
Fast forward in 20 years interest rates are 10% and the price of the TLT is $80 (bond prices typically go down when interest rates rise. The principal amounts you would receive in this scenario would be:
1) “Individual Bond” – You get back the original $10k
2) “Bond Fund” – You sell 80 shares of TLT for $80 and get back $6400
Why does this affect your retirement ?
Nearly all 401k plans only offer Bond Funds – these have no guarantee of return of principle. You are not buying something with price stability – bond prices can fall significantly when interest rates rise. This is not predict the future, but there is a fair chance that interest rates will be higher than the current FED rate of 0.25% today by the time the 401k money needs to be used (assuming you are more than 10 years from retirement). The rate does not have to move up many % points for secondary market bond price to drop significantly.
In a bond fund you are always marking to market based on the secondary market price for today. With an individual government bond you can mitigate the principal risk, because you can always hold to maturity with the implicit guarantee that your government of will still exist (!). This demonstrated actual principal safety versus perceived principal safety.
Potentially you are risking significant principal in a bond fund, even though they are often marketed as a “safe bet”. Implication is that you are guaranteed to get your principal back, but that is not necessarily true.
What to do ?
Convert 401k to Traditional IRA if you leave your current employer – and invest in individual bonds (if you can diversify enough.
Types of bond risks
With either individual bonds or bond funds you are taking either government (Sovereign) or company pricing risk in the secondary market.
Government Bonds – Typically for government bonds in developed nations (such as the USA, Canada, major European nations) these bonds come with an implicit guarantee that the country in question will not default (and the yields are priced accordingly). The compensation for this increased safety comes with a reduced yield. Whether you believe that particular countries implicit guarantee is up to you -see 1998 Russian financial crisis for an interesting case study.
Non government Bonds – bet on the stability or increase of overall bond prices in the secondary bond market. This bet implies a controlled default rate across a wide selection of bond in the appropriate fixed income category (e.g. junk, corporate, emerging markets). Compensation with higher yield.