Are bond funds an adequate substitute for a portfolio's bond allocation?

[AJDZee]

To all those who've decided to hold bond funds (ex. vanguard BND), instead of individual bonds in their portfolio as their 'safe bond allocation' to hedge against the relatively riskier stock portion...

Do you consider bond funds to provide that level of safety?
It seems like everyone on here holds a large portion of bond funds as their bond holdings, and consider that to be the safe part of their portfolio.

Am I missing something? Other than having 'bond' in the name, Bond funds don't seem to hold the same level of safety as individual bonds or treasuries, the fact that you don't receive the par value at maturity, it's just re-invested, leaves you with just the avg coupon rate as a return, but the capital investment you put in (which makes up +90% of the value of the investment) is exposed market fluctuations.

Clearly I am new to bond investing - keep that in mind :)

[dividendman]

I hold a bunch of BND (Vanguard Total Bond Market ETF).

It is less "risky" than stocks regarding volatility. It's probably more risky than stocks with regards to inflation and interest rate risk and long term returns.

That being said, holding individual bonds doesn't provide more safety if the duration and yield of the bond is the same as the average duration and yield of the bond fund.

It might seem safer to hold an actual bond, but it's the same, because if you want to use the principal of the bond, you need to sell it, and if interest rates went up since you bought the bond, you have to sell at a discount (loss). The same is true for a bond fund.

[nereo]

consider how one might build a portfolio with actual bonds during their accumulation phase.  Let’s say you have $2k to invest each month, and want a conservative 60/40 AA.  Each month you would purchase $1,200 in stocks, and $800 in bonds.  With that amount to invest you might buy 5, 10 and a few 30 year T-bonds, every month. 

After five years your first batch of 5 year notes will have reached maturity, and you will buy more.  Ditto once you hit the 10 year mark.  For several decades every month you will cash out the bonds which have matured and purchase new ones. The yields will vary considerably from month to month, year to year, but over time it will all average out.  After 30 years of diligently saving you’ll have 60 batches of 5 year notes, 120 batches of 10 year notes and a whopping 360 batches of 30 year notes, and each month one batch from each will mature.  Sometimes they will pay out a lot more than current yields, other times they will be a lot less.

In other words… your portfolio would act very much like the bond funds that everyone invests in, only it would be a lot more work.

[AJDZee]

Thanks, nereo and dividendman


Your walk through of how tedious it would be to buy individual bonds, is part of my theory why people use funds over bonds - but that trade-off for convenience leads people to buy a completely different product, no? (in my mind at least, because I'm still not seeing how they are the same)

As an example, if you invested $10k into bonds for 10-years

Option 1: buy 10-year bond
$10k in bonds @ let's say 2.5%,
you receive $2500 in interest, plus your $10k after 10 years
total value after 10 years is $12,500


Option 2: buy BND and hold for 10 years
BND price in March 2013 ~$83/unit, at 2.5% yield(?)
you get 120.5 units
over 10 years you get $250x10 = $2500
today's BND price is $71.80 (-14%)
total value after 10 years is $11,150


Clearly I'm still missing something, because they don't seem to have the same risk profile.
bond funds seem to have a similar risk profile as like a high dividend yield ETF or something...

If you'd rather point me in the direction of where I can learn more, rather then respond with a lengthy lesson on bonds, I'd be happy to read. thanks!

[dividendman]

I think a simple way to look at it is like this:

If there was a bond fund that only held 10 year treasuries (i.e. it sold all of it's treasuries every month or whatever and bought the new 10 year treasury) then we would get the same result as if we both held a 10 year treasury assuming interest rates didn't change.

If you buy a 10 year treasury and hold it until maturity and never buy a bond again because that's all you need from your bond allocation, you're implicitly making a bet that interest rates are going to go down and you want to lock in your rate. But most people want a bond allocation after 10 years.

If I buy my imaginary 10 year fund that cycles to new 10 year treasuries at every bond payment, I'm betting that interest rates are going to go up since I'll get the new better yield as they rise.

The reason BND lost value is that they still own bonds at the end of the 10 years... so you can't compare it to the 10 year treasury.... I think the above made sense. lol.

The problem with your example is that your 10 year treasury ends in 10 years and you just keep the money but don't say what happens next. If next you want to invest in bonds again then it's the same as BND in that if interest rates went down, you lost out (compared to BND which constantly buys at the market rate to keep it's duration and effective maturity goals in tact) since you can't get a rate that existed 5 years ago.

[Heckler]

If you'd rather point me in the direction of where I can learn more, rather then respond with a lengthy lesson on bonds, I'd be happy to read. thanks!

TLDR:

https://www.bogleheads.org/wiki/Bond_basics

https://www.bogleheads.org/wiki/Individual_bonds_vs_a_bond_fund

[ChpBstrd]

Bond funds exist mostly for the convenience factor, but they also have a couple of other benefits:

1) Liquidity: Bond trading is not at all instantaneous like stock trading, and one's order might execute only when prices go down unexpectedly. Funds like BND, AGG, and LQD trade practically every second during market hours. This might be important to those who want to hold bonds for a little while and then quickly sell to pounce on an opportunity. You don't have to wait until the next day to find out if your order was processed or cancelled!

2) Options: Funds like BND and LQD have options markets where you can enter a position by selling a put or earn additional cash off your position by selling a call. For example, LQD pays a dividend of $3.69/year. If you want the shares anyway, you could earn an additional $1.63/share of that within just 28 days by selling an ATM put option. This bumps your realized "yield" far above what the shares themselves pay! Unless you miss a dividend, this is an easy way to take roughly the same downside risk as owning shares but juicing your returns. There are not many other ways to juice one's returns in the bond world!

Regarding the convenience factor, the largest one is related to minimum lot sizes. Shop for individual bonds in the secondary market and you might find minimum investments of $5k, $10k, or even $50k due to minimum lot sizes, or worse pricing for small minimum lots. For folks investing their paychecks, it probably makes sense to pay a fund some very small expense ratio to trickle money into these otherwise inaccessible markets. The alternative is to invest in big lumps periodically and accept fewer options or worse pricing.

[Scandium]

Thanks, nereo and dividendman


Your walk through of how tedious it would be to buy individual bonds, is part of my theory why people use funds over bonds - but that trade-off for convenience leads people to buy a completely different product, no? (in my mind at least, because I'm still not seeing how they are the same)

As an example, if you invested $10k into bonds for 10-years

Option 1: buy 10-year bond
$10k in bonds @ let's say 2.5%,
you receive $2500 in interest, plus your $10k after 10 years
total value after 10 years is $12,500


Option 2: buy BND and hold for 10 years
BND price in March 2013 ~$83/unit, at 2.5% yield(?)
you get 120.5 units
over 10 years you get $250x10 = $2500
today's BND price is $71.80 (-14%)
total value after 10 years is $11,150


Clearly I'm still missing something, because they don't seem to have the same risk profile.
bond funds seem to have a similar risk profile as like a high dividend yield ETF or something...

If you'd rather point me in the direction of where I can learn more, rather then respond with a lengthy lesson on bonds, I'd be happy to read. thanks!

I'm hardly an expert on bonds, but I feel like you're assuming some market timing here; buying an ideal bond vs a fund. A bit like "why buy VTI when I could just have bought AAPL 10 years ago?" ...

As interest rates change even a bond held to maturity will loose in "value". Sure you'll always get your principal back, but if rates rise you could have gotten a better return by selling at a loss and buying a higher-yielding bond. Which is what the fund does. Your 2.5% 10-year bond isn't so great if rates go to 5% a few years in. Of course this won't always be the case, so then yes buying individual bonds on your own would do better, but be a huge hassle..

[AJDZee]

Thanks, nereo and dividendman


Your walk through of how tedious it would be to buy individual bonds, is part of my theory why people use funds over bonds - but that trade-off for convenience leads people to buy a completely different product, no? (in my mind at least, because I'm still not seeing how they are the same)

As an example, if you invested $10k into bonds for 10-years

Option 1: buy 10-year bond
$10k in bonds @ let's say 2.5%,
you receive $2500 in interest, plus your $10k after 10 years
total value after 10 years is $12,500


Option 2: buy BND and hold for 10 years
BND price in March 2013 ~$83/unit, at 2.5% yield(?)
you get 120.5 units
over 10 years you get $250x10 = $2500
today's BND price is $71.80 (-14%)
total value after 10 years is $11,150


Clearly I'm still missing something, because they don't seem to have the same risk profile.
bond funds seem to have a similar risk profile as like a high dividend yield ETF or something...

If you'd rather point me in the direction of where I can learn more, rather then respond with a lengthy lesson on bonds, I'd be happy to read. thanks!

I'm hardly an expert on bonds, but I feel like you're assuming some market timing here; buying an ideal bond vs a fund. A bit like "why buy VTI when I could just have bought AAPL 10 years ago?" ...

As interest rates change even a bond held to maturity will loose in "value". Sure you'll always get your principal back, but if rates rise you could have gotten a better return by selling at a loss and buying a higher-yielding bond. Which is what the fund does. Your 2.5% 10-year bond isn't so great if rates go to 5% a few years in. Of course this won't always be the case, so then yes buying individual bonds on your own would do better, but be a huge hassle..

Thanks, Scandium.

See here's the funny part - from my perspective, in your explanation above you are the one who's suggesting market timing :) (no offense!)
Bringing in speculation of interest rate changes, what that could do to the value (if the bond is sold on secondary market) or what you *could have been getting* if you bought bonds during higher interest rates.

Whereas the 'buy and hold' nature of individual bonds - you accept the yield you get at the time, and wait for the principle at maturity, providing that predictability/low-volatility is what the safe bond part of your portfolio should be doing. Not having the principle value swing back and forth to market conditions - you have stocks to provide that higher risk/reward for you.

I'm pretty sure the Trinity Study that everyone on here has bought into assumed holding individual bonds to maturity, not bond funds, right? would the study have been the same if bond funds were used as the bond part of the portfolio?

I'm sure something will 'click' in my head eventually on why bonds and bond funds turn out to be exactly the same, and I'll get onto the same level that everyone who is responding in on. Just asking questions to learn!

[Scandium]

Thanks, Scandium.

See here's the funny part - from my perspective, in your explanation above you are the one who's suggesting market timing :) (no offense!)
Bringing in speculation of interest rate changes, what that could do to the value (if the bond is sold on secondary market) or what you *could have been getting* if you bought bonds during higher interest rates.

Whereas the 'buy and hold' nature of individual bonds - you accept the yield you get at the time, and wait for the principle at maturity, providing that predictability/low-volatility is what the safe bond part of your portfolio should be doing. Not having the principle value swing back and forth to market conditions - you have stocks to provide that higher risk/reward for you.

I'm pretty sure the Trinity Study that everyone on here has bought into assumed holding individual bonds to maturity, not bond funds, right? would the study have been the same if bond funds were used as the bond part of the portfolio?

I'm sure something will 'click' in my head eventually on why bonds and bond funds turn out to be exactly the same, and I'll get onto the same level that everyone who is responding in on. Just asking questions to learn!

Too lazy to check, but I'm pretty sure the trinity study used bond funds. Additionally; it also assumes rebalancing from bonds to stocks during downturns! Which doesn't work if you're holding to maturity so you'd loose that benefit.

I disagree that a fund is any more market timing; it gives you an "average" of bonds, regarding interest rate and duration. Rather than picking one and holding. It's perhaps not as bad as doing the same with stocks, since you know what you'll get at the end. Regardless; to me the hassle of individual bonds removes this from the consideration, even if it's technically superior. I invest constantly on a bi-weekly basis, so managing this would be too much. In any case I don't even own any bonds at this point, since I'm accumulating and see no need for them (yet..) :D  But it's an interesting discussion.

[scottish]

Bond funds have occassionally bought negative yield bonds, back when interest rates were ridiculously low.    Any comments on this?    I presume they were doing this in order to mirror their target index.

But it would have been better to hold cash...

[seattlecyclone]

Bond funds have occassionally bought negative yield bonds, back when interest rates were ridiculously low.    Any comments on this?    I presume they were doing this in order to mirror their target index.

There's nothing magical about the number zero that makes bonds with yields less than that number obviously not worth investing in, while yields higher than that number are. All else being equal, of course you'll want the higher yield, but that higher yield often comes at a cost of higher risk of default. What would you rather invest in: a one-year bond with a -1% interest rate and no risk of default, or a +1% interest rate with 5% risk of default? The expected value of that negative-yield bond is greater. Of course "cash under the mattress" is also a strategy that you need to evaluate in comparison to these bonds, but holding cash isn't riskless either. Physical currency comes with real risk of theft and loss from disasters such as fire. These risks can be mitigated by hiring guards, buying safes, making sure those safes are fireproof, etc., but that's not free. Cash at a bank is insured in relatively small amounts, but something like a Vanguard bond fund operates at a much higher scale than FDIC limits, so banks come with risks too. How do these risks (of holding physical currency or a bank account above FDIC limits) compare to the cost of holding a negative interest rate bond? So long as that negative rate isn't very negative it can still be a rational investment to make in an environment when nobody aside from junk bonds is paying much more than zero.

[scottish]

Bond funds have occassionally bought negative yield bonds, back when interest rates were ridiculously low.    Any comments on this?    I presume they were doing this in order to mirror their target index.

There's nothing magical about the number zero that makes bonds with yields less than that number obviously not worth investing in, while yields higher than that number are. All else being equal, of course you'll want the higher yield, but that higher yield often comes at a cost of higher risk of default. What would you rather invest in: a one-year bond with a -1% interest rate and no risk of default, or a +1% interest rate with 5% risk of default? The expected value of that negative-yield bond is greater. Of course "cash under the mattress" is also a strategy that you need to evaluate in comparison to these bonds, but holding cash isn't riskless either. Physical currency comes with real risk of theft and loss from disasters such as fire. These risks can be mitigated by hiring guards, buying safes, making sure those safes are fireproof, etc., but that's not free. Cash at a bank is insured in relatively small amounts, but something like a Vanguard bond fund operates at a much higher scale than FDIC limits, so banks come with risks too. How do these risks (of holding physical currency or a bank account above FDIC limits) compare to the cost of holding a negative interest rate bond? So long as that negative rate isn't very negative it can still be a rational investment to make in an environment when nobody aside from junk bonds is paying much more than zero.

I can't think of any circumstance that would apply to me where holding a negative yield bond is better than holding cash.    Not only is cash more liquid, it's paying a better yield.  Or rather you're not paying it a yield.   Even if your cash was in SVB, the fed has agreed to make you whole, and the major banks in Canada are much more stable than SVB.    Owning a bond index fund that holds negative yield bonds, well, I'd agree with your assessment - that's subject to a risk/reward analysis.

[vand]

Christ, why do people get so confused over this.
Yes. Bond funds are suitable for a fixed income allocation in your portfolio.

Not only are they suitable, they are the preferred choice in most circumstances due to liquidity and constant duration - you don't want to hold all your bonds to maturity and have to renew your matured bonds each year under most circumstances.

Either way there is no free lunch whether you are buying the note directly or a fund.  If you buy a fund you accept the interest rate risk that comes with the duration. If you buy a note you hold it to maturity and then take the inflation hit at the end on the returned principle.

[scottish]

Hey are you talking about me?    How am I confused?