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Target Retirement Funds: Bond Funds vs Actual Bonds?
Old 10-22-2007, 08:56 PM   #1
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Target Retirement Funds: Bond Funds vs Actual Bonds?

My employer now has various years of "Target Date" retirement funds, that start out heavily in stocks and gradually shift to more bonds as you near retirement. I could pick any target date I desire, not just my actual date; that would allow me to have a higher percentage of stocks than my actual date would produce.

The stock funds have done pretty well over the years, and have a very low expense ratio. I am satisfied with them.

However, I see a potential problem with the bond allocation. If we are, as I suspect, in a period of gradually rising interest rates; then the interest gains on the bonds will be somewhat (maybe a lot) reduced by capital losses on the market value of the bonds. That does not happen if I buy individual bonds and hold them to maturity. Of course, the plan might buy bonds and hold them to maturity, but the paperwork does not say that; I don't think so because time to retirement + expected length of retirement would require buying 40 years bonds even for an older guy like me.

What comments or suggestions do you have?
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Old 10-22-2007, 09:07 PM   #2
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Think about this for a second.

What's the difference between you owning bonds and a bond fund owning bonds? Well, other than the fee they charge you each year.

They can also hold the bonds to maturity, or sell at a capital gain or loss, just like you. Since they are holding hundreds of bonds, they probably have a bond maturing almost every day. Those proceeds are used to buy new bonds at the prevailing market rate. They are buying new bonds all the time as cash flows in. And selling bonds all the time as redemptions are made.

In other words, a bond fund with average maturity M and duration D will behave pretty much like a bond of maturity M and duration D that you hold yourself.
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Old 10-22-2007, 09:37 PM   #3
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Im trying to latch onto this one also. Ive always avoided bond funds for the reasons OP stated.....I don't have control of the term, but have to accept whatever Maturity and Duration the fund happens to have (especially with limited choices within a 401k). I finally took the plunge last summer when I decided rates were not going higher, only to watch my bond fund underperform during the recent volatility. I have not yet dug into the mechanics, but this experience has me thinking Bonds YES, Bond Funds NO.....especially if I can get a PenFed CD occaisionally @6-6.25%

It seems to me that the bond fund manager MUST purchase bonds at prevailing rates to achieve some desired yield which influences the maturity, duration, and volatility/correlation of the fund. I can be more selective than a bond fund manager in timing my purchase only when the terms are satisfactory. In addition to limited choices, my 401k just went to a slew of co-mingled pools that are private funds managed by PIMCO, but not sure how much data is available for them.
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Old 10-22-2007, 11:25 PM   #4
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Buying bonds directly from Treasury is definitely cheaper than holding bond funds. Other than zero-coupon bonds, interests are tax-deferred. However, bond funds provide ease of diversification and less paperwork. I am not aware employers are offering that option for retirement accounts.
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Old 10-23-2007, 12:04 AM   #5
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However, bond funds provide ease of diversification and less paperwork.
My thoughts exactly. Bond funds may not be ideal, but they are convenient. I don't really want to hold dozens of individual bonds and research each and everyone of them. I figure that I pay a small fee for a fund manager to do the work for me (though I think that for bond funds especially, a no-load, low expense ratio fund is a must).

However, I must say, if you want a higher degree of capital preservation, individual bonds are probably the way to go. If interest rates go up, you can hold the bond to maturity and get your principal back (well if the bond issuer has not defaulted by then). With a bond fund there is no maturity date and no guarantee that you will recover your principal.
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Old 10-23-2007, 12:20 AM   #6
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With a bond fund there is no maturity date and no guarantee that you will recover your principal.
You can't calculate an exact date when you're guaranteed to get your principal back, but I think there is an upper bound.

A bond's total return = principal + interest. Duration is defined as the time when a bond (or fund) will return 1/2 of the expected total return. Therefore, if you hold a fund for 2 * duration, I believe you're guaranteed to have received the total expected return (via dividends) and you'll still be left with the value of the fund you're holding at that time.

In either case, I believe your expected return over time is the same (ignoring fund expenses) if you hold individual bonds or a bond fund.

Some bond fund managers might even add enough value to clear the fund expenses. Google "riding the yielding curve" for example.
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Old 10-23-2007, 12:43 AM   #7
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twaddle,

Interesting perspective. I never thought of it this way. But I guess, it makes sense, if you hold the bond fund forever, then there should be little differences between a bond fund and individual bonds (except as you mentioned the ER).
But since the bond fund is always in flux (buying new bonds, redeeming old ones...), and since there is no good time to sell a bond fund (because there is no maturity date), if you sell the bond fund at any point in time, then wouldn't you leave some of the returns of the newer bonds on the table? It may not have a huge impact, especially if you hold the fund for a long enough period of time, but what do you think?
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Old 10-23-2007, 01:00 AM   #8
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Obviously, you can realize a capital loss by selling a bond fund (or individual bond) when interest rates have moved higher than the rate at the time you bought.

But you'll then be in a new rate environment, so as long as you reinvest the proceeds at the new (higher) rate, your total return over time will still come out the same as if you had originally held an individual bond to maturity.

It would be fun to create a bond fund simulator to verify this, but it would require knowledge of all bonds in the portfolio, when they're sold, when new bonds are purchased, etc. So, you just need to go with a warm fuzzy logical argument that the risk of a capital loss in a bond fund shouldn't be any different than letting your bonds mature and reinvesting the proceeds. Sadly, I don't know of any mathematical proof.
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Old 10-23-2007, 01:17 AM   #9
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It would be fun to create a bond fund simulator to verify this, but it would require knowledge of all bonds in the portfolio, when they're sold, when new bonds are purchased, etc. So, you just need to go with a warm fuzzy logical argument that the risk of a capital loss in a bond fund shouldn't be any different than letting your bonds mature and reinvesting the proceeds. Sadly, I don't know of any mathematical proof.
Hey, your fuzzy logical argument sounds good to me. The mathematical proof sounds like too much work...
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Old 10-23-2007, 03:23 AM   #10
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My crystal ball is broken... so I just decided to diversify some of my equity into bond funds. I did it when equities are riding high (in our tax deferred accounts).

From here, what do I intend to do? I am at 70/30 and my target is 60/40... I intend to average in more into bonds over the next several years. Of course, I will move funds from the equity funds that are doing well. I am trying to keep the bonds in the tax deferred accounts.
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Capital Preservation
Old 10-23-2007, 10:07 AM   #11
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Capital Preservation

is the only reason I can see to buy bonds directly, and I'm not sure the NAV fluctuation of a bond mutual fund should be too terribly vexing. Perhaps a compromise would be to hold a relatively small amount of directly purchased Treasuries or CDs along with cash and the rest in bond funds. The directly purchased and some cash will buffer you from withdrawing during poor markets and in the mean time you can benefit from the probably better dividends from funds which purchase corporates, GNMAs, etc.

Paul Merriman's take:

FundAdvice.com - Paul Merriman: 10 reasons I favor bond funds
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Old 10-23-2007, 12:39 PM   #12
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is the only reason I can see to buy bonds directly, and I'm not sure the NAV fluctuation of a bond mutual fund should be too terribly vexing. Perhaps a compromise would be to hold a relatively small amount of directly purchased Treasuries or CDs along with cash and the rest in bond funds. The directly purchased and some cash will buffer you from withdrawing during poor markets and in the mean time you can benefit from the probably better dividends from funds which purchase corporates, GNMAs, etc.

Paul Merriman's take:

FundAdvice.com - Paul Merriman: 10 reasons I favor bond funds
I agree 100%, I think a good bond manager can outperform the best "ladderer", becasue they can leverage more money and get access to the best initial issues............
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