When interest rates rise, or are expected to, stockbrokers urge conservative investors to buy individual bonds. They appear to be safer than bond mutual funds. Just this week, I caught the following headline in an investment publication: "Individual bonds can help protect income."
That's 100 percent wrong. Individual bonds deprive you of extra income when interest rates go up, as well as expose you to other risks. Investors who understand the trade-offs choose bond mutual funds.
This goes against conventional wisdom, so I'll start with a quick explainer before listing all the reasons for my choice.
In a bond mutual fund, the managers constantly buy and sell bonds. The daily share price of the fund reflects the bonds' current market value, minus fees. When interest rates go up, bond values go down -- and so does the share price of bond mutual funds. If you sell, you might not get your original principal back. When interest rates fall again, as they will in the next business cycle, the share price will go up.
Investors who hate to see share prices fluctuate buy individual bonds, usually in bond ladders. That's a series of bonds maturing at different times. A typical ladder might contain one-year, three-year, five-year, 10-year, and 20-year bonds. Each time a bond matures, you can spend the money or reinvest in more bonds. The market value of these bonds fluctuates, too, but you don't see it. People who choose ladders plan to hold to maturity, at which point they'll get their original principal back.
Now for my case against ladders:
1. Bond ladders deprive you of current income. The money you put into individual bonds pays you an income at a fixed rate. When rates in the marketplace go up, your income will stay the same. In a bond mutual fund, by contrast, the managers will be adding higher-rate bonds to the pool. Your interest income -- and spending money -- will increase.
2. Bond ladders often force you to reinvest at lower rates. If you're not spending the interest income you get from individual bonds, you need to reinvest it. What are you doing with that money? It might not be enough to buy more than one or two bonds, at a high commission cost. If you want that money to be readily available, you'll siphon it into a money market fund whose interest rate is kissing zero.
In a bond mutual fund, by contrast, you can reinvest all your interest income in new shares, at the market's current, higher yields. In other words, you'll be buying more shares at a lower price. When interest rates decline again, the value of your bond fund shares will rise. You'll have more shares than you started with, which means more dollars in your pocket.
3. Bond ladders deprive you of future capital gains. When you hold individual bonds and interest rates decline, your bonds will rise in market value. They'll be worth more than you paid for them. But in ladders, you hold to maturity so you'll never collect the capital gains. In a mutual fund, the manager will harvest those gains and add them to the value of your shares.
4. Bond ladders carry more default risk. Individual investors might hold no more than 10 or 20 bonds. If one of them goes bad, it could take a mean slice out of your portfolio. Ladders should be built only with high-quality bonds but -- in municipals, especially -- you never know when a snake is hidden in the underbrush.
Mutual funds are far better diversified, owning hundreds, even thousands of bonds (Vanguard's Intermediate-Term Tax-Exempt fund holds 4,641 of them). Like ladders, the bonds come in varying maturities, from short to long.
5. Bond ladders leave you unprepared for emergencies. Sometimes, you can't hold individual bonds to maturity. You might have unexpected medical bills or one of your kids might need some cash. You might have inherited the bonds and want to convert them into cash. Selling bonds before maturity is more expensive than you imagine. If interest rates have risen, their market value will be down -- especially for small, retail lots. The markets trade in amounts of $100,000 or more, and clip 2 to 3 percent off the price if you're selling just 25 or 30 bonds. You pay your broker a sales commission. And, after the sale, you don't have a ladder any more -- one or more of the rungs is gone.
With a mutual fund, on the other hand, you can sell shares at any time and at no cost if you have a no-load fund. The remainder of your investment will be just as diversified as it was before.
6. Bond ladders are expensive. You'll probably work with a broker to set one, paying 2 percent in markups, at retail price. The ladders have to be managed, meaning more sales commissions. A no-load mutual fund, by contrast, charges no commissions and costs only a small amount per year in management fees -- at Vanguard, about 0.2 percent. Also, funds buy their bond at institutional prices, which are much lower than the price you pay in the retail market.
7. What about other kinds of ladders? Ladders built from certificates of deposit instead of bonds face many of the same drawbacks: No increase in income when interest rates rise and a penalty if you're forced to sell before maturity. The same is true of ladders built from Treasury securities. But with Treasuries, there's no default risk and you don't have to pay sales commissions (for Treasuries, you'd have to build the ladder yourself, using Treasury Direct).
Bottom line: "Investors are hurting themselves, when they choose ladders over funds," says Francis Kinnery, a principal in Vanguard's Strategy group. Ladders serve an emotional need for certainty, which might matter to you more than anything else. Just don't think that this move outwits the markets. Nothing does.
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