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Choosing Between Individual Bonds and Bond Funds in Your Investment Portfolio

When investors are looking at their bonds, one of the most common questions is whether they should use individual bonds or bond funds (either in the form of mutual funds or ETFs) in their investment portfolio. Interest rates have come up over the past few years, so the yields on bonds have also come up. And with those higher yields it seems a lot more attractive to lock in these returns than it has in the past.

But that’s a little deceiving.

It’s easy to compare the current yield on an individual bond with a bond fund’s historical returns, but that’s not the right way to think about it. We all remember the anemic returns from bonds over the past decade or so (and can definitely see them when we look at the historical returns on whatever bond fund you’re looking at) so it’s natural to be attracted to the yields that we are seeing now. But the better way to think about is that, to a first approximation, comparable individual bonds and bond funds have the same expected return. This makes sense – a bond fund is just someone holding a bunch of individual bonds, and then selling little pieces of ownership in those bonds.

The decision will really come down to what you are looking to do with the bonds.

If you are looking for reliable income, that’s exactly what individual bonds are there for. They’re great if you want to hold them to maturity and then spend the proceeds – all of the cash flows are locked in (assuming the bond doesn’t default), so you know exactly how much money you will be receiving, and when you will be receiving it. Which is definitely not the case with a bond fund.

But if you are looking to use these bonds within your investment portfolio, you will probably want to use bond funds. There are three big reasons for this: Rebalancing, Convenience and Reinvestment Risk.

Let’s take a look at each of these in turn.

Bond Funds Make Rebalancing Easier

Even though we usually think of individual bonds in terms of having fixed cash flows, their prices aren’t fixed. Even if we don’t care about the price because we’re going to hold it to maturity (which is what you want to do if you’re using the bond for reliable income), the market value of that bond will be constantly changing. And even if the price of the bond wasn’t bouncing around, the rest of your portfolio is. So that means we need to think about rebalancing and how to keep your portfolio in line. Especially because the ratio between stocks and bonds is the most important decision you’ll make about your portfolio.

The problem is, depending on the specifics of your portfolio (and how big of a chunk of your bonds we’re talking about here), using individual bonds can make rebalancing really awkward.  Individual bonds are more difficult to trade than a bond fund. As an individual you are going to be getting the short end of the stick every time you want to buy or sell an individual bond. You’re going to get a bad price, and it might not even be possible to find exactly what you are looking for when you want to rebalance.

Basically, when we’re trading bonds, the smaller the amount you’re looking to buy or sell the worse you’re going to get hit on the price (as individual investors we’re always going to be on the bad side of the trade – it’s just a question of how bad it’s going to be). This means that not only will rebalancing be more expensive when you are using individual bonds, it might mean that you won’t be able to keep your portfolio in line with your asset allocation.

If this is a tiny portion of your bonds, then it might not come into play, but if it is a reasonable sized chunk of your portfolio it will make it harder to keep your portfolio in line with your asset allocation. And if it is a small piece of your bonds, then it won’t make that big of a difference to your overall returns – which brings us to the next point.

Bond Funds Make Your Life Easier

On the flip side, bond funds simplify your life. It’s a lot easier to deal with bond funds than individual bonds – and this often gets overlooked. You want to actually be out living your life, not arguing with the bond desk at whatever custodian your IRA is at (though I’m not going to judge if this is what you like doing). It’s just simply easier be able to buy and sell a bond fund (either mutual fund or ETF) than it is to deal with buying and selling individual bonds – even aside from the price issue.

You’re paying for this convenience with the expense ratio on the fund, but bond funds are pretty cheap, and I think it’s worth it – especially when you are managing your portfolio yourself.

Individual Bonds Mean Reinvestment Risk

This last point is also one that I think gets overlooked a lot when investors are deciding between individual bonds and bond funds. When you are holding an individual bond to maturity as part of your investment portfolio (and not for reliable income), you are choosing to take a massive helping of reinvestment risk.

Individual bonds pay out a lump sum at maturity, leaving you with a chunk of cash that needs a new home – and we have no way of knowing what the market will look like at that point in time. And you can’t really get around this by saying you’ll see early, because both the value of the bond is bouncing around, as well as the pricing issue we discussed earlier.

So, where does this leave us?

Well, the question really comes down to whether you want the ability to lock in a set of specific cash flows with individual bonds or whether you want the ease of use and flexibility from bond funds. And if you are looking to keep your bonds as part of your investment portfolio, bond funds hit all of the boxes. They offer the flexibility and convenience necessary to adapt to changes in your retirement plan, maintain your desired risk profile, and, frankly, make your life a bit easier.

Remember, retirement planning isn’t just about numbers on a page; it’s about ensuring a comfortable retirement. Bond funds, with their blend of simplicity and flexibility, align well with this objective, letting you focus more on living the retirement that you want and less on managing the nitty-gritty of your investment portfolio.

To find out more about investing in retirement, read our eBook 8 Tips to Becoming a Retirement Income Investor

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