Bonds vs. Bond Funds? An Easy Choice!

(MoneyWatch)  I'm often asked whether an investor should buy individual bonds or a bond fund. The answer is crystal clear.

Here are the two arguments I typically hear:

• One should own bond funds in order to build a more diversified portfolio. Owning even a couple of dozen individual bonds exposes the investor to undiversified credit risk if an issuer defaults.
• One should own individual bonds because bond funds give an unnecessary risk in that their value moves with interest rate changes. If interest rates go up, the value of the bonds and bond funds go down. But if you hold the individual bonds until maturity, in a laddered portfolio, you eliminate this risk since they generally mature at par. No such guarantee exists with funds since they are constantly buying additional bonds.

It seems like an endless debate of either taking on more default risk or more interest rate risk. But often in the world of investing, what seems to be true isn't.

The myth of eliminating interest rate risk
As it turns out, the argument that holding a bond to maturity eliminates interest rate risk is completely false. Let's look at this example:

You buy a one-year bond today for $1,000 that promises to pay back $1,050 in one year. The interest rate is 5 percent ($1,050 - $1,000)/$1,000. The value of the bond today is $1,000, calculated as follows:

1,050/1.05 = $1,000

Your luck happened to be really bad and immediately after buying this bond, the CPI showed unexpected inflation and interest rates shot up. Seconds after buying this bond, the same bond is now yielding 6 percent. A new bond would now be paying $1,060 in a year. The bond you bought, however, is giving you back only $1,050, so now the value of your bond is calculated as follows:

1,050/1.06 = $990.57

Or, a decline of $9.43 from the $1,000 you paid.

Because interest rates went up by 1 percent, the value of your bond dropped by $9.43 or 0.94 percent. If you keep the bond for the entire year, you'll get $1,050 back and won't have the loss, right? Well, not so fast. Remember that the new bond is paying 6 percent, so you missed out on buying the $1,000 bond that would have paid $1,060, or an additional $10.00. So, holding onto the bond has an opportunity cost of:

$10/1.06 = $9.43

It's no accident that the decline in value is exactly equal to your opportunity cost of holding it to maturity. Bond markets are extremely efficient. Holding a bond to maturity, even in a laddered portfolio, provides no protection from interest rate risk.

An additional benefit of bond funds - liquidity
But bonds can be sold, right? I have no argument with that, though they are still not as liquid as an open-ended no-load bond fund. A no-load bond fund can be sold without a cost. Even a bond ETF can be sold at a minimal cost and the bid-ask spread is usually less than 0.05 percent, or five basis points.

Individual bonds, on the other hand, can have bid-ask spreads of fifty to five hundred basis points. No, this isn't a typo. You will, unfortunately, have no idea that you are paying these hefty fees to the market maker. This is one of the financial industry's dirty little secrets. Okay, maybe not so little.

My advice
Low cost bond index funds provide professional management with very low costs. In return for paying as little as 14 basis points (0.14%) annually, you get diversification and liquidity. This is a bargain, in my book. Some good high quality bond funds include a Total Bond Index fund from iShares or Vanguard.

So the next time you hear that a laddered bond portfolio eliminates interest rate risk, remember the opportunity cost example above. Then politely thank the broker and walk away.

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