Bond Investing vs Bond Funds

[Freedom56]

In an environment of rising interest rates like in 2022, bond funds can lose money. There is risk there. Buying an individual bond eliminates that risk because you know exactly what you are going to get if you hold it to maturity. When holding an individual bond and interest rates go up, there is an opportunity cost for holding that bond because you are missing out on potentially higher returns but you still get your principal back. Another thing is that you can actually lose money in a bond fund if its management decides to sell out some of its bonds for cheap if they aren't doing well..

When you ease into a ladder with shorter duration notes (1-5 years) with a focus on 2-3 years as rates rise, you lessen the risk of opportunity cost. As coupon payments come in quarterly or semi-annually you re-invest at higher yields. The big advantage you have over a fund is you can strategically time your purchases and adapt your duration to the yield curve and market conditions. There is no rush to be 100% invested especially given that money market funds yield more than short duration bond funds. Furthermore as I stated early in the year, tax loss selling season creates some of the best opportunities. But looking at the big picture, those started buying bonds this year are buying high grade notes at 4.5%, then 5%, and now 6%+ are much better off than a fund that is holding a .38% treasury through 2026. The average coupon of a short duration ladder this year will be over 5% with high grade notes versus 2.2% average coupon for most short duration funds. You will be earning more than double the income with capital protection that a fund cannot offer. If rates continue to rise, you continue to compound at higher yields. If rates begin to fall, a portfolio with an average coupon of over 5% will outperform one with and average coupon of 2.2%. This is all simple math.

 

[big-papa]

I really don't understand how duration matching works compared to holding a ladder. To keep it simple, let say you have a ladder with one rung. Over the last ten years from the stats I see most bond funds would have lost NAV. TIPS funds would either have lost NAV in the 5 year period or been way behind inflation for the 10 year period. Individual bonds would have kept their principal if bought and redeemed at par. TIPS bought at par and held to maturity would have kept up with inflation.

I don't understand how having one fund or more is going to change the basic math of funds losing NAV in a rising rate environment, individual bonds retaining principal and individual TIPS increasing in value like I bonds with inflation (bought at par and held to maturity). Maybe someone can explain it to me how this would work because I really don't get it.

Everything I have read about bond funds says they have market risk and you never know if you will get more or less of your principal back when you need to redeem your shares. I don't see how having more than one fund changes this math. Two bond funds will still have variable future outcomes, unknown at the time of shares purchase.

Thought I posted this before but couldn't find it.

High Level Concept explained here:
https://occaminvesting.co.uk/duration-matching-an-introduction/
https://occaminvesting.co.uk/duration-matching-in-practice/

The ongoing (long) thread over on bogleheads on the subject:
https://www.bogleheads.org/forum/viewtopic.php?t=318412
There are other threads where this is brought up as well. Too many to list, but the posts above from occam investing refer to a number of posts on bogleheads on this subject.

A backtest that a BH'er made with available data.
https://www.bogleheads.org/forum/viewtopic.php?p=6934228&hilit=enjoyment#p6934228

Cheers.

 

[daylatedollarshort]

Thought I posted this before but couldn't find it.

High Level Concept explained here:
https://occaminvesting.co.uk/duration-matching-an-introduction/
https://occaminvesting.co.uk/duration-matching-in-practice/

The ongoing (long) thread over on bogleheads on the subject:
https://www.bogleheads.org/forum/viewtopic.php?t=318412
There are other threads where this is brought up as well. Too many to list, but the posts above from occam investing refer to a number of posts on bogleheads on this subject.

A backtest that a BH'er made with available data.
https://www.bogleheads.org/forum/viewtopic.php?p=6934228&hilit=enjoyment#p6934228

Cheers.

I think it is plainer to just look at the published performance returns of the TIPS or other bond funds over the last 1, 5 and 10 years, but YMMV. Individual bonds would return their original principal, TIPS would be inflation adjusted which has been around 20% for 5 years and 28% for the last ten years. You have stated in other posts you don't care about NAV, but that is like saying you don't care if you don't if you only get half your original investment back.

Bond yields are up, TIPS real yields are up and when that happens the funds get creamed and no complicated charts or formulas really change that. If rates go back down to near zero and TIPS yields return to negative, the funds will go back up. If they go up even more the funds will do even worse. Holding more funds doesn't change the basic math.

Individual investors can also switch between bonds and funds to whatever is paying more, which many of us did this year by selling funds early in the year when interest rates were still low and avoiding the steep losses. We can also market time, as Freedom56 points out. Most investors aren't going to buy long term bonds at 1% or less, or TIPS at negative yields, but the funds are forced to do that. Individual investors can wait things out until rates improve. So these formulas and charts which ignore return of the original investment dollars, assume one can only hold funds or bonds, and assume individuals act like the funds and don't market time, don't really work like the real world does.

Did the BH bond experts know that the funds were going to crash early this year when rates were going to go up 6 - 7 times? Did they know they could have avoided those losses by switching to individual bonds, while rates went up? Because that advice was readily available in this forum.

 

[Freedom56]

It's time to dispense with the Boglehead theories, back testing, or whatever and apply some common sense. Those theories are nothing but a futile attempt to justify flawed theories that are not based on reality today. Stand back and look at the big picture. Bond funds are holding too much low coupon debt and it will take many years for a fund's average coupon to match those of risk free investments today. A money market fund yields more than a short duration bond fund. Treasuries and CDs are paying over 2x the yield of bond funds and corporate notes are paying 3-4 times.
A money market fund maintains a $1 NAV. The short duration bond fund has no protection from capital losses. The longer the duration, the more the fund is doomed. This is a fact of life today. The only thing that could change that is if rates dropped and turned negative. Funds manage their average duration and that in addition to redemptions, that is one of the biggest weaknesses due to duration stripping. They will sell bond with a duration less than a year at a loss and replace them with bond at a longer duration. So in the example of VFSUX holding a 0.38% coupon 2026 note, it will be forced to sell that note in 2025 and if rates are around where they are today, they will realize a loss. Holding a bond to maturity will result in 100% return of capital but individual bond investors would never lock in 5, 10,20, 30, and 40 year durations at ultra low coupons. Nor would they buy bonds at negative yields. But a passive bond fund will do just that. That is irrational behavior that Bogleheads fail to realize with their so called analysis and back testing. All of their so called analysis assumes that someone managing a bond ladder would make the same irrational purchases a bond fund would do. Individual fixed income investors are always adjusting durations and rarely are 100% invested. You can call it market timing, but this is normal behavior for fixed income investing. If the Fed moves rates up to their target of 4.5-4.8% (normal rates), Treasury and CD yields will be consistently over 4%, agency notes over 5%, and high grade corporate notes will be over 6% and high yield notes over 8%. This means that investors that bought callable CDs, agency notes, and corporate notes earlier this year have reduced their call risk and will be able to compound their coupon payments at current yields. Without inflows, bond funds will be treading water or continuing their buy high sell low mode of operation.

 

[youbet]

I just use the Fidelity bond index funds - Fidelity US Bond Index and Fidelity Short-Term Bond Index funds. These are extremely low cost index funds with expense ratios of only 0.025%. There are additional Fidelity low cost bond index funds available with narrower focus such as intermediate treasury index fund etc.

Thanks!

 

[daylatedollarshort]

Related links:

This article explains how the supercycle of global declining interest rates has reversed this year for the first time in decades and what that has meant for bond funds - This Is Why You Should Ditch Your Bond Funds And Buy Some Bonds Instead (from last June)

Switching between bonds and funds as an option, with tax loss harvesting as a bonus - Bonds Are Having a Rough Year. Here Are 3 Actions That Can Help | Kiplinger

The worst investment for 2022 - Hint: They are all long term bond funds (from 1/5/2022) - The Worst Income Investments for the New Year | Barron's (barrons.com)

 

[Letj]

If the Fed moves rates up to their target of 4.5-4.8% (normal rates), Treasury and CD yields will be consistently over 4%, agency notes over 5%, and high grade corporate notes will be over 6% and high yield notes over 8%. This means that investors that bought callable CDs, agency notes, and corporate notes earlier this year have reduced their call risk and will be able to compound their coupon payments at current yields. Without inflows, bond funds will be treading water or continuing their buy high sell low mode of operation.

Assuming this becomes reality shortly, how will this impact the stock market? Doesn’t this remove the incentive to invest in stock with relatively low risk investments yielding 6-8%.

 

[COcheesehead]

Assuming this becomes reality shortly, how will this impact the stock market? Doesn’t this remove the incentive to invest in stock with relatively low risk investments yielding 6-8%.

Yep.

 

[Freedom56]

Assuming this becomes reality shortly, how will this impact the stock market? Doesn’t this remove the incentive to invest in stock with relatively low risk investments yielding 6-8%.

Stocks will correct for that reality. The CEO of JP Morgan seems to think so. I don't own stocks and I only pay attention to company financials.

 

[Quattro73]

To the point that some common sense needs to be applied…..I have seen it mentioned that BND is yielding “4.36%” (in a thread last week on another forum). I assume they meant SEC Yield

My response:

“BND is not.

At todays price it would cost me $69.41 for a share on BND.
It’s last 6 months of dividends are:

Oct - 0.1561
Sept - 0.1565
Aug - 0.1533
July - 0.1487
June - 0.1480
May - 0.1408

A 4.36% yield on $69.41 is 0.25 per month plus.
It has a a long way to go to get there.”

I will let anyone decide on their own whether to continue to hold existing money in these funds and hope it comes back.

But investing new money is insane at this time. You are not yielding a reasonable return relative to individual treasuries, new issue CDs, and quality corporates.

 

[Freedom56]

I will let anyone decide on their own whether to continue to hold existing money in these funds and hope it comes back.

But investing new money is insane at this time. You are not yielding a reasonable return relative to individual treasuries, new issue CDs, and quality corporates.

In the long run, common sense prevails.

 

[daylatedollarshort]

Here is another link on the differences between bonds and bond funds, this one from Schwab. For those that think there are no major differences between the two and that each choice will even out over time, you might want to read this article: "One key difference between individual bonds and bond funds is that with bond funds, there's no guarantee that you'll recover your principal at a specific time, particularly in a rising-rate environment....As interest rates rise and fall, the NAV of a given bond fund will fall and rise respectively, and there's no certainty as to what the NAV may be at a point in the future. This makes bond funds less attractive than individual bonds when planning for future liabilities."

TIPS bond fund returns, even over 10 and 5 year periods, have been varying wildly this year as TIPS yields change. If there can be drastic changes from week to week with the fund NAVS, then how can they possibly be similar to individual TIPS, where, if bought at par, you back your principal or the inflation adjusted amount, whichever is greater. One week you might make more with the funds, the next week it could be less. The fund returns are unpredictable.

https://www.schwab.com/learn/story/bonds-vs-bond-funds-which-is-right-you

 

[njhowie]

I will let anyone decide on their own whether to continue to hold existing money in these funds and hope it comes back.

But investing new money is insane at this time. You are not yielding a reasonable return relative to individual treasuries, new issue CDs, and quality corporates.

I believe this is primarily short-term thinking. A quick look at the yield curve shows that going out more than 1 year with treasuries it is inverted. With CDs, for the best yields available, it's essentially flat at 3 years and longer.

As most folks around here know, I avoid bond funds and "only" invest in (primarily municipal) individual bonds.

HOWEVER, recently, we adjusted DWs 401k/403b contribution percentages, with the entire 403b contribution and employer match portion of her 401k going in to a bond fund. This bond fund is now priced lower than it's ever been since inception 35 years ago...15% lower than the original offering price. The yield is now higher than it's been in well over a decade and continuing to trend higher, and I have absolutely no doubt that in time shares will return to highs seen just last year. The fund will easily outperform longer term treasuries and CDs available today.

All that being said, I just put in an order for mom, for some new issue Ally 3-year 5.1% callable CDs. That's an exceptional yield whether it goes to maturity or is called early. She has a called municipal bond being redeemed next week and if this 5.1% 3-year or better is available I'll get more for her with those proceeds.

 

[Quattro73]

I believe this is primarily short-term thinking. A quick look at the yield curve shows that going out more than 1 year with treasuries it is inverted. With CDs, for the best yields available, it's essentially flat at 3 years and longer.

As most folks around here know, I avoid bond funds and "only" invest in (primarily municipal) individual bonds.

HOWEVER, recently, we adjusted DWs 401k/403b contribution percentages, with the entire 403b contribution and employer match portion of her 401k going in to a bond fund. This bond fund is now priced lower than it's ever been since inception 35 years ago...15% lower than the original offering price. The yield is now higher than it's been in well over a decade and continuing to trend higher, and I have absolutely no doubt that in time shares will return to highs seen just last year. The fund will easily outperform longer term treasuries and CDs available today.

All that being said, I just put in an order for mom, for some new issue Ally 3-year 5.1% callable CDs. That's an exceptional yield whether it goes to maturity or is called early. She has a called municipal bond being redeemed next week and if this 5.1% 3-year or better is available I'll get more for her with those proceeds.

What is the fund actually paying out?

 

[Gumby]

...My order for Goldman Sachs 6.75% shows "execution pending". Sure it's a callable bond. But I will earn 6.75% for at least one year and 100% return of capital in the worst case....

With a non-governmental borrower, there is always a risk that you won't receive 100% return of capital if the borrower goes into Chapter 11. Since it's Goldman Sachs, that risk is miniscule, but it is not zero.

 

[Rianne]

With a non-governmental borrower, there is always a risk that you won't receive 100% return of capital if the borrower goes into Chapter 11. Since it's Goldman Sachs, that risk is miniscule, but it is not zero.

If you buy an agency bond, isn't the risk even less?

 

[Gumby]

If you buy an agency bond, isn't the risk even less?

I would assume that US Treasury bills/notes/bonds and other US governmental agency bonds are equally risk free, but I don't know for sure, and I'm too lazy to research it.

 

[COcheesehead]

If you buy an agency bond, isn't the risk even less?

They are just about the same as buying a CD. They are not insured, but pretty close to a treasury. They can be callable.

 

[daylatedollarshort]

I have absolutely no doubt that in time shares will return to highs seen just last year. The fund will easily outperform longer term treasuries and CDs available today.

What if rates go up even higher? That is the chance you take with bond funds. The shares might go higher or drop even lower. It depends on what happens to interest rates in the future.

 

[Freedom56]

Just a word of caution about Fidelity and the fund industry. After 2008/2009 crisis many funds took some serious losses. In 2010, just about every equity fund offered by Fidelity in our 401K plan were renamed and new symbols were assigned to these funds. The performance prior to 2010 was completely erased and they started measuring performance from 2010. Whatever holdings that remained in the funds were carried over to the new fund under they new symbol. These are the type of games these asset managers play. The reason they did this was pretty clear. In 2010, their stable value and Ginnie Mae funds outperformed their equity funds over the past decade. It didn't fit their narrative that equities outperform fixed income and other investment over the long term. At some point, some of these longer duration bond funds EFTs will have to make decisions to sell their holdings at a loss and buy back higher paying bonds to boost their distributions. Otherwise they are doomed. Take a look at TLT as an example the weighted average coupon is only 2.14% with an average duration of 25.4 years. The SEC yield of 4.14% is meaningless. It is even lower that a 30 year treasury that has zero risk to capital. Investors normally receive a premium yield to treasuries for risk. This is how the credit market functions. It always has and always will. TLT and other funds like AGG, and BND offer no risk premium, no capital preservation, and half the income that a corresponding duration treasury pays. That makes no sense whatsoever and eventually will correct itself. Common sense and normal credit risk rules applied in the past and they will in the future.

 

[njhowie]

What if rates go up even higher? That is the chance you take with bond funds. The shares might go higher or drop even lower. It depends on what happens to interest rates in the future.

LOL - I'm well aware of the chance you take with bond funds. You're talking to someone with a 1/99 AA where up until now that 99 is individual bonds, CDs, and treasuries.

What if rates go even higher? Then yield on the bond fund goes even higher. Yes the shares may go lower, but acquiring bi-weekly with DW's paycheck will get us more shares over time. Again, it is her 401k/457b (my mistake - it's 457b, not 403b as stated in prior post). There are only a fixed selection of funds to choose from, about half target date. I'm very familiar with this particular bond fund, and am happy to be getting it at the current price/yield. Until now, 100% of her funds there have been in money market. Let the bond fund go lower from here - longer term it goes higher...because rates are not going to be this high years and years in the future. That's my view, and how I'm investing.

If you're investing in equity funds, you should be asking yourself the same questions.

 

[njhowie]

After 2008/2009 crisis many funds took some serious losses. In 2010, just about every equity fund offered by Fidelity in our 401K plan were renamed and new symbols were assigned to these funds. The performance prior to 2010 was completely erased and they started measuring performance from 2010.

T. Rowe Price and Janus did similar with internet bust in 2000. Merged poor performers into better performers, changed names/symbols, etc.

 

[daylatedollarshort]

LOL - I'm well aware of the chance you take with bond funds. You're talking to someone with a 1/99 AA where up until now that 99 is individual bonds, CDs, and treasuries.

What if rates go even higher? Then yield on the bond fund goes even higher. Yes the shares may go lower, but acquiring bi-weekly with DW's paycheck will get us more shares over time.

That is different than the post I replied to, in which you said, "I have absolutely no doubt that in time shares will return to highs seen just last year. The fund will easily outperform longer term treasuries and CDs available today."

You might want to check the past performance results for bond funds. As Freedom56 points out, some bond funds have been down in share price for the last 5 to 10 years, or for some since inception lately, depending on current market rates. Per the Schwab article in the previous post, "with bond funds, there's no guarantee that you'll recover your principal at a specific time, particularly in a rising-rate environment."

 

[njhowie]

That is different than the post I replied to, in which you said, "I have absolutely no doubt that in time shares will return to highs seen just last year. The fund will easily outperform longer term treasuries and CDs available today."

You might want to check the past performance results for bond funds. As Freedom56 points out, some bond funds have been down in share price for the last 5 to 10 years, or for some since inception lately, depending on current market rates. Per the Schwab article in the previous post, "with bond funds, there's no guarantee that you'll recover your principal at a specific time, particularly in a rising-rate environment."

Thank you for your concern.