Should You Buy Individual Bonds or Invest in a Bond ETF or Fund?

Posted by Alex Frey (@alexhfrey )

When investing in stocks, most people intuitively understand the difference between buying shares of a single company like Apple and buying an index fund or ETF that tracks the entire US stock market. The second portfolio will clearly be far more diversified than the first. But when investing in bonds, the situation is a bit murkier and less clear. In this article, we'll look at why that is and develop a framework to understand when it makes the most sense to buy an individual bond, and when it is better to buy a bond fund or ETF.

A Brief Reminder of What a Bond Actually Is

Before delving into the details, it's important to have a firm understanding of what a bond actually is. You'd be surprised how many get this step wrong!

At a basic level, a bond represents an IOU from a corporation or government to the bond holder. The bonds that we will discuss in this article are US Treasury bonds, so the IOU is to the US Government, which is legally obligated to pay you back (and can print money in order to do so!).

Bonds have a few characteristics you should be aware of. First, the “term” of the loan is legally set from the start. When a bond matures, the issuer essentially “repays” you the full face amount of the bond, also known as the “principal.” Confusing things somewhat, this is not necessarily the same amount that you purchased the bond for – depending on the prevailing interest rates, bonds can trade at a premium or discount to their face value. Because the coupons a bond pays are fixed, its price will go up when interest rates go down, and down when rates go up.

Second, there are a set of pre-determined coupons that are paid over the bond's terms that function as the equivalent of interest.

The most important numbers to know about any Treasury Bond is how many years are remaining until it matures, and what the “yield to maturity” is on the bond. The “yield to maturity” is a way of calculating the interest-rate on the bond. It is essentially the return that you are guaranteed to earn if you own the bond to maturity and re-invest all of the coupons. If you purchase a bond at face value on the date it originates, then the yield-to-maturity would be the same as the annualized coupon rate (coupon value per year divided by the face value).

The “yield curve” (representation of interest rates vs. maturities) is calculated from assembling the yield to maturities of different maturities of zero-coupon bonds (bonds that do not pay a semi-annual coupon). Usually, bonds with longer maturities will pay higher rates then those with shorter ones.

A bond fund or ETF is simply an instrument that buys up many individual bonds.

Why Diversification Is Not So Big of a Deal In Treasury Bond-Land

The biggest reason to invest in a stock ETF instead of purchasing individual shares is the diversification benefits that come from owning an entire index of stocks vs. owning just one or two individual stocks.

These same benefits apply from owning bonds that are subject to default risk, like those issued by corporations. Here, it makes sense not to place all your eggs in one basket.

But the situation is a bit different if you are considering investing exclusively in Treasury Bonds, which is actually something that we would recommend because we think that most investors are better off getting their corporate exposure through purchasing common stocks. What makes Treasury bonds different is that their issuer (the Treasury Department) has practically zero chance of defaulting, since the government can always print money in its own currency. And even if the US government were to cease paying back its debt (which, to be clear, is exceedingly unlikely), owning a diversified spectrum of Treasury Bonds likely would not help, since they all have the same issuer anyway.

This doesn't mean that every Treasury Bond is functionally the same. As we've already discussed, the single largest factor that separates Treasury Bonds from one another is their time until maturity. Some bonds will last only a year, others may last thirty years. One measure of the length of a bond is its time to maturity. A somewhat better measure of the length of a bond is known as its "duration"*. The difference between these two measures is beyond the scope of this article.

So does it make sense to construct a diversified portfolio of Treasury Bonds with different durations?

The answer is “not really.” That's because at a portfolio level, the key thing to focus on is your average duration. As a first order approximation, owning a collection of 100 bonds with a weighted-average duration of 8 years is not terribly different than owning a single Treasury bond with a weighted-average duration of 8 years. Your portfolio will respond in a similar way when interest rates go up or down.

The Biggest Difference Between Owning an Individual Bond and Owning a Bond Fund

While there are no great diversification benefits to be had in Treasury-bond land, there are some significant differences between owning bonds outright and through an ETF.

A key thing to internalize about owning bonds outright is that the characteristics of an individual bond will change as it gets closer to its maturity date. Long-term bonds will inevitably turn into short-term bonds after the passage of some time.

To put this concretely, if you buy a 20 Year Treasury Bond yielding 2.5%, in ten years time you will no longer have a 20 Year Treasury bond yielding 2.5%. You will have a 10 Year Treasury Bond that probably yields some lower amount by virtue of the fact that its price will have appreciated a little (because interest rates are generally greater on longer-term bonds than on shorter-term bonds, particularly at times like today when the yield curve is highly “sloped”). This shorter-term bond will function differently than the longer-term bond that you initially bought.

Since longer-term bonds have quite different risks and returns than short-term bonds, if you wanted to retain exposure to longer-term bonds in the context of your portfolio, you would have to constantly “re-balance” your Treasury bonds by selling your old bonds and buying newer, fresher ones.

ETFs and Treasury bonds make this relatively easy by doing this for you. A bond fund will typically have a mandate to keep its average duration around the same level, so as its bonds “age”, it either sells them and replaces them with new ones, or just manages its overall portfolio to maintain a fairly constant duration.

So one way to think about a long-term Treasury bond fund, such as TLT, is that it's like a long-term Treasury bond that never ages.

If You Buy an Individual Zero-Coupon Bond and Hold it to Maturity, Your Returns Are Guaranteed

Some people are attracted to bonds because of the guaranteed nature of their returns. After all, the sector is frequently known as “fixed” income. If you are one of those, it is critical to realize under what circumstances your returns are actually “fixed.”

Specifically, the only time your returns are truly guaranteed is when you purchase an individual zero-coupon Treasury bond and hold it to maturity. Under these conditions, the bond will always pay you its face value when promised (barring any defaults or other extreme events), so you can calculate your return ahead of time and you'll never be off. It is worth repeating: A zero-coupon Treasury bond held to maturity is the closest thing to a risk-free long-term investment that exists anywhere in the world – under 99.99% of scenarios, it will always return the amount that it says it will.

If you purchase a regular coupon-paying Treasury bonds, your returns are “mostly guaranteed”, but you won't know ahead of time what rate you will be able to re-invest your periodic coupon payments.

We should probably say a word about what these “guaranteed returns” do and do not mean before moving on. If you purchase an individual bond in your brokerage accounts, it will get “marked to market” on a daily basis, even if it is a zero-coupon bond. This means that it will appear to increase and decrease in value along with the rest of the market. But so long as you hold the bond to maturity, this volatility is largely an illusion, because its value will always converge to the face value of the bond on the date it matures. Another way of saying this, is that the returns of a zero-coupon bond are guaranteed over the lifetime of the bond, but they are not guaranteed on a day to day or month to month basis. A portfolio of zero-coupon Treasury bonds held to maturity will be volatile, but not ultimately risky.

This is really important to understand, so let's look at one more example. Suppose you pay $60,000 today to purchase a $100,000 face-value zero-coupon bond that will mature in ten years time. Next year, that bond could be worth $70,000 or $65,000, or even $55,000 depending on where interest rates go. But in ten years time, it will always be worth $100,000, because that is how much the government has promised to pay you at that time. So you can calculate your returns over the ten year period as 5.2% a year annualized. But next year it could still “look like” you are up 5% or down 10% .

Your Returns From Purchasing a Bond ETF are Never Guaranteed, But They Do Have More Upside Than Holding an Individual Bond

Unlike buying a regular bond, purchasing an ETF does not guarantee your returns. Since the fund will always be buying some bonds and selling others, if you invest that same $60,000 today, there is no telling whether it will be worth more or less than $100,000 ten years from now. If you own an ETF, you have to actually care somewhat about the day-to-day and year-to-year volatility.

The benefit of this is that buying an ETF keeps your interest-rate constant over time, rather than letting it decrease. All else equal, this should have the advantage of increasing your expected returns (notice the use of “expected”, your actual, “realized” returns might be higher or lower).

In times when the yield-curve is positively sloped, buying a bond fund can sometimes be advantageous as a result of “riding the yield curve.” This effect occurs when the slope of the yield curve remains constant between the time that a fund buys a bond and the time that it sells it in order to re-balance back into longer-term bonds. If this is the case, then the price of the bond that is sold will have increased slightly due to this effect (this is because the bond still has the same coupon payments, but is now priced at the lower, short-term rate).

An example might make the riding the yield curve impact more clear.

If you need money a year from now, you could buy a one-year Treasury yielding near 0, or you could buy a 30 year Treasury yielding 3% and then sell it a year later.

Suppose you choose the latter option. When you go to sell it, the 30 Year Treasury that you bought will be a 29 year Treasury that will yield (let's say) 2.95%, so the price will have gone up slightly (assuming there is no change in interest rates), and you would have also received a 3% coupon in the mean-time (assuming the bond was bought at its face value). So you could get a return of something like 3.5%, instead of the near-zero return you would have gotten from investing in a one-year bond.

This seems like a good deal, but of course it is not a free lunch: you have to believe that both the level and structure of interest rates is unlikely to change in order for it to be consistently profitable. If interest rates go up in the mean time, you could lose quite a bit of money holding the 30 Year Bond, whereas you are insulated from losing any money by holding a bond to its maturity. If you truly need money a year from now, it is a better idea to buy the shorter-term bond, even if you are giving up some potential return.

When to Buy Individual Bonds and When to Buy ETFs

So when is it a good idea to buy bonds in ETFs, and when is it a good idea to buy them outright?

First, you have to understand why you want to buy bonds. There are generally two good answers to this question (and a lot of other bad ones...).

The first good answer is that you want to own bonds as part of your growth portfolio. This is the bucket of money that you will need sometime in the future to cover your living expenses, but which you do not need immediately and are willing to take some risks with. The reason to put some of this money in bonds, rather than to own all stocks, is to stabilize your returns in a market downturn and give you a liquid vehicle to re-balance back into stocks on the upswing. These objectives are best served with a bond ETF. That's because it makes more sense to keep your diversification constant in this scenario – doing so will allow you to achieve full diversification benefits; it will keep the characteristics of your portfolio constant, and it will likely slightly increase your returns over the long-term as a result of extending your duration. Plus, it is just simpler and easier.

The second reason you might buy a bond is as part of a “risk-free” portfolio. Here, the objective is to set aside enough money today to partially or totally fund an anticipated future expense. For instance, if you anticipate you will need $50,000 five years from now, and the current yield-to-maturity on a five-year zero-coupon bond is 3.50%, then you could set aside about $42,000 today and be basically guaranteed of being able to meet the expense five years from now. This scenario will apply most directly to those who are already in retirement who may want to build a “bond ladder”, but if you are setting aside a fixed amount of money for a home down-payment or kids education, it could also apply to you. This objective is best served by directly purchasing a zero-coupon bond and holding it to maturity. This option takes interest-rate risk largely out of the equation, guaranteeing your returns for the future. It is the only truly risk-free way to go, though if you believe that your spending needs are best expressed in real, after-inflation terms, then you might consider purchasing a TIPs bond.

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By Alex Frey