Bond Funds or Bonds?

[sengsational]

I don't understand this change in holding bond funds due to a bad 2022. How is this different from stopping holding equities due to 2022? You have a long term plan that makes simplicity and long term gains the priority. One year changes the results, and scraps the whole plan? Recency bias is pervasive and makes us all feel safer. If you like to buy individual bonds, by all means keep doing that. But don't let one year change your long term plan of simplicity.

The difference is that one simply can't predict anything about the equity market, whereas the ability to predict bond fund NAV and yields is going to be in a narrow band, and there will be plenty of signals; if you are paying just a little attention and have a little knowledge of how things work, you won't find that you have completely missed the boat, which is almost certainly the case with equities. But what I'm talking about is "timing". That's become a dirty word, but in the bond world, it shouldn't be. The fed starts making noises about raising rates? (as was the case a year ago) As a bond fund holder, you've already lost some, but if the fed follows through, you'd be way ahead just bailing out and buying individual bonds. If the fed decides to cut rates, as an individual bond investor, that will become obvious. I suppose, for simplicity, you could buy the fund again, and ride up the NAV... nothing stopping you. But I get simplicity. You leave some on the table and line some pockets, but it's easier.

 

[COcheesehead]

I like municipal funds for taxable accounts. Both Vanguard and Fidelity have good offerings. It would be difficult for me to pick out (and monitor) individual muni bonds; unlike the corporates, I don’t know any of the issuers.

I have more muni bonds than any other because we live off our taxable account interest.
Munis are pretty straight forward. They are rated by third parties so that is a guide. They also have to publish material events, MEs, that will expose any issues. They then fall into two categories: revenue and general obligation - GO bonds. Revenue bonds are backed by the revenue of the project, toll road, hospital, water project, etc. GO bonds are backed by taxation (think schools, etc) and therefore considered a bit safer, though both types are safer overall then corporate bonds. Revenue bonds will pay you more for the risk. If you have a state tax, buying your state specific muni will also allow you to avoid the Fed and state tax.
I have owned hundreds of individual muni bonds. Never had a default and as I said we live exclusively off our tax free interest. I currently own 130-140 muni bonds. I just read the MEs which are a handful a week. The interest is deposited into our account about every two weeks on average. They just work.

 

[aja8888]

I have more muni bonds than any other because we live off our taxable account interest.
Munis are pretty straight forward. They are rated by third parties so that is a guide. They also have to publish material events, MEs, that will expose any issues. They then fall into two categories: revenue and general obligation - GO bonds. Revenue bonds are backed by the revenue of the project, toll road, hospital, water project, etc. GO bonds are backed by taxation (think schools, etc) and therefore considered a bit safer, though both types are safer overall then corporate bonds. Revenue bonds will pay you more for the risk. If you have a state tax, buying your state specific muni will also allow you to avoid the Fed and state tax.
I have owned hundreds of individual muni bonds. Never had a default and as I said we live exclusively off our tax free interest. I currently own 130-140 muni bonds. I just read the MEs which are a handful a week. The interest is deposited into our account about every two weeks on average. They just work.

Just curious, but what's the best YTW you are seeing (roughly) and at what agency rating(s) for GO or revenue bonds? Got any advice on what states to feel safe about?

I'm looking at some Houston, TX utility bonds (insured) that are callable and with YTW around 3.5% @ $95+. These mature in three years rated AA/A1..

 

[COcheesehead]

Just curious, but what's the best YTW you are seeing (roughly) and at what agency rating(s) for GO or revenue bonds? Got any advice on what states to feel safe about?

I'm looking at some Houston, TX utility bonds (insured) that are callable and with YTW around 3.5% @ $95+. These mature in three years rated AA/A1..

I don’t buy under par because I don’t want the capital gain. I also don’t look outside of Colorado because I want the double tax free benefit. I can buy CO revenue bonds in the mid 4% range. GO are closer to 4% at best. Those are AA+ ish ratings. Anything with a A in front is golden.
I stick to the ladder process - maturing bonds get reinvested on the long end.

 

[aja8888]

I don’t buy under par because I don’t want the capital gain. I also don’t look outside of Colorado because I want the double tax free benefit. I can buy CO revenue bonds in the mid 4% range. GO are closer to 4% at best. Those are AA+ ish ratings. Anything with a A in front is golden.
I stick to the ladder process - maturing bonds get reinvested on the long end.

Thanks, I should probably stay away from buying under par for the same reason. The 4% range sounds like what I should be shooting for.

 

[Phroig]

I don’t buy under par because I don’t want the capital gain. I also don’t look outside of Colorado because I want the double tax free benefit. I can buy CO revenue bonds in the mid 4% range. GO are closer to 4% at best. Those are AA+ ish ratings. Anything with a A in front is golden.
I stick to the ladder process - maturing bonds get reinvested on the long end.

Does de minimis not apply to aja's bonds? I thought for bonds maturing in 3 years, the discount would need to be less than 0.75% to qualify for capital gains.

 

[COcheesehead]

Does de minimis not apply to aja's bonds? I thought for bonds maturing in 3 years, the discount would need to be less than 0.75% to qualify for capital gains.

It has to be less than .25% of the face value per year for it not to apply. So for his example probably not. I just avoid below par because they usually have lower coupons and I am an income investor in addition to potential cap gains.

 

[daylatedollarshort]

I don't understand this change in holding bond funds due to a bad 2022. How is this different from stopping holding equities due to 2022? You have a long term plan that makes simplicity and long term gains the priority. One year changes the results, and scraps the whole plan? Recency bias is pervasive and makes us all feel safer. If you like to buy individual bonds, by all means keep doing that. But don't let one year change your long term plan of simplicity.
YMMV.

VW

This is the first time since mutual funds became pervasive we've had a significant resurgence in inflation / interest rates. It has been a wake up call to a number of us here that bond funds aren't really fixed income and don't always offset stock losses. Neither the principal nor the interest are fixed with the funds. So, yes, now that I personally understand bond funds and the risks better, especially thanks to Freedom56, I have changed my investment plan.

I knew to sell the long term bond funds last year but I was surprised at how much even the floating rate and short terms funds were starting to lose so I sold those, too, and may never go back. I also didn't understand the stale pricing and hidden fees as much before Freedom56's posts, but I see that now in the bond performance stats and the distribution yields vs. SEC yields.

It is different than holding equities because stock funds do mimic holding individual stocks but bond funds do not mimic holding individual bonds, explained in detail in the article in this post - https://www.early-retirement.org/forums/f28/bond-vs-bond-fund-114703-9.html#post2816309

I find it easy enough to buy my own bonds now. YMMV. I didn't change my plan due to one bad year. I changed it because I have a better understanding of the risks of bond funds than I did before.

 

[sengsational]

This is the first time since mutual funds became pervasive we've had a significant resurgence in inflation / interest rates.

Back in the mid 80's my BIL tried to get me to understand the bond fund vs bonds thing, but I didn't take any action. I was under the mistaken impression that when my stock funds zigged, bond funds would zag. In 1988, I was smacked with the realization that bond funds aren't bonds. I should have been in the SVF, but that was throwing off very little at the time. In retrospect, I should have been 100% equities. This time, at an age where my AA does need ballast, I was in the SVF, mostly, in the 401k. I needed more, though, and there was no opportunity in that bucket except for a bond fund, so I held my nose and used that for a long while. But even the shortest bond fund option was a dog as the rates came up, so I gave up flexibility in my equities allocation and gave myself flexibility in the bond allocation. Having tax buckets makes it a challenge, but not impossible...I just dumped the bond fund and bought an equities fund in the one account while concurrently selling my specific equities and buying individual bonds in the other account. This left my overall AA unchanged.

 

[Henry Lili]

CDs and i-bonds, for example, are not subject to changes in principal value. Instead you forfeit part of your interest if you close out early.

Bonds and funds of bonds generally are subject to losses of principal. If you notice, virtually all classes of bonds and bond funds lost money last year.

Invesco Bullet Shares could be a middle ground.

Plus 1

 

[foxfirev5]

After spending the last 7 years creating a bond/CD ladder to cover future spending, I really don't see any difference between my ladder and my bond funds of similar maturity/duration. If I'm honest with myself I must look at the market value rather than the hold to maturity par value of the individual bonds. The % increase/decrease is nearly identical for the individual holdings vs funds.

Now that my bond ladder of CD's, Treasuries and TIPS is complete, all new FI reinvestments are going into a short term treasury fund and an intermediate term fund. Time to sit back and enjoy the ride. More importantly I don't want to leave anyone with a big mess of individual holdings when I'm no longer here.

 

[big-papa]

With the recent rise in interest rates, investors have renewed interest in investing in bond funds, ETF's and bonds. This is the thread to discuss the pros and cons of owning bonds indirectly through funds, ETFs etc. versus owning them directly.

While acknowledging there is no single approach is right for everyone this is the place to discuss the advantages and disadvantages of each.

Feel free to recount personal experiences or discuss individual strategies.

I will start with Open-End Bond funds, which are the most common type of bond mutual funds. This is not all advantages or disadvantages, add your own.

Open End Bond Funds:

Advantages:

-Can start small
-Diversified portfolio which reduces risk at first dollar invested
-highly liquid so easy to buy and sell, ready market. Easy to use to rebalance
-Managers of large funds have buying power to minimize transaction costs
-Easy to research fund strategy and holdings
-Investors may choose from a wide range of durations, strategies and types of holdings

Disadvantages:

-In a changing interest rate market, investors may flee funds, which may add selling pressure to bond markets and affect performance
-In a changing interest rate market, investors may rush into funds, making it tough for managers to invest new funds efficiently
-No fixed maturity, so no way to mitigate losses by holding securities to maturity (but Invesco "Bullet Shares" and similar products may address this)
-Fee structure may be a drag on returns (but low cost funds may mitigate this)
-In times of rapid rate changes, fund results may trail market due to fund structure
-if fund holdings are illiquid fund values may be challenged in times of rapid change in underlying bond values

That is a start, probably many more.

Most folks probably make their first bond investments through funds or ETFs, mainly I suspect because of the convenience of doing so.

Did you take this path, and if so what attracted you to bond funds?

During my accumulation years, I owned bond mutual funds. Basically they were considered as just another low-correlated-to-stocks asset to smooth the road a bit. I used primarily nominal treasury bond funds, long at first and then ratcheted down to intermediate as I got close to retirement.

As I enter retirement, I now care about income streams and I do a form of duration matching using bond funds, using ETFs. One can also do the same thing via bond ladders. In my case, it's now only TIPS. TIPS + SS will give me a nice floor of inflation adjusted income for which I can tolerate gyrations in the stock market for the remainder of my spending.

Cheers.

 

[big-papa]

Cash flow. Some people set up their investments to generate a certain monthly cash flow.

Other folks don’t care about the cash income generated by their investments.

You have to decide which type of investor you are: an income investor or a total return investor.

This is basically it in a nutshell!

And sometimes we switch teams or become hybrids. I was a total return investor during accumulation and now I'm an income investor (via bonds) AND a return investor (via stocks), though even total return investors at some point usually convert their stock holdings to cash over time to create something to live on.

 

[latexman]

Here’s my bond fund experience inside my Fidelity 401k. My AA target is 60/40. I have 3 bond funds out of the 5 that are offered in my 401k. The fixed income funds I have are a Stable Value Fund (23%), FXNAX (10%) and VIPIX (7%). Over the last year, the SVF returned 1.4%, which made it the champion of my bond funds last year. Here’s what FXNAX and VIPIX did:



At the trough, FXNAX lost 15% from the peak, and now it has recovered 5%. At the trough, VIPIX lost 19% from the peak, and now it has only recovered 1%.

I’m seeing noise in the financial news media that bonds funds are recovering. FXNAX seems to support that, but VIPIX, not so much. Mixed signals, a false narrative, or a little of both? Hmmm.

Probably like a lot of folks, after a year of losing I was wondering if I should “stay the course”, or not. Should I abandon bond funds entirely? Well, I did initiate some changes yesterday. I sold all the SVF (returning 1.4% p.a.) and bought the one money market fund in our 401k, FIGXX, that is currently returning 4.2% p.a. FIGXX's returns has increased in lock step with the Fed increases. So, at present and looking forward into 2023, this change seems to be in the direction of goodness. I plan on doing the same for my VIPIX, unless something drastic happens soon (it probably won’t), and I will keep an eye on FXNAX. So, I’m mostly abandoning bond funds right now, but not 100%.

More info. I’m still working. I will be retiring late in 2023. At that time, I’ll roll the traditional 401k portion of my 401k into my Fidelity tIRA, and the Roth 401k portion of my 401k into my Fidelity Roth IRA (opened in 2015). I used to think retaining the SVF in my 401k may be a good long term idea, but I just realized I have gutted that idea! Something else to noodle on.

Once I retire and roll these funds over, I’ll have a lot more flexibility and access to bonds!

Comments, advice, questions?

 

[daylatedollarshort]

If I'm honest with myself I must look at the market value rather than the hold to maturity par value of the individual bonds. The % increase/decrease is nearly identical for the individual holdings vs funds.

The being able to hold to maturity is the main advantage of bonds vs. bond fund in a rising rate environment. So of course if you ignore the main advantage you aren't going to see as much difference between the two. The lack of a maturity date is what makes the funds more volatile. You never know in advance what the price will be when you want to sell.

 

[COcheesehead]

The being able to hold to maturity is the main advantage of bonds vs. bond fund in a rising rate environment. So of course if you ignore the main advantage you aren't going to see as much difference between the two. The lack of a maturity date is what makes the funds more volatile. You never know in advance what the price will be when you want to sell.

Correct. The mark to market pricing will create volatility in an individual bond just as much as a fund, but the key is the bond will return to a known amount at a known date. So liability matching or bridging to pensions, SS, etc becomes far more predictable.
Individual bonds provide income like a fund, but also capital preservation.

 

[Out of Steam]

The being able to hold to maturity is the main advantage of bonds vs. bond fund in a rising rate environment. So of course if you ignore the main advantage you aren't going to see as much difference between the two. The lack of a maturity date is what makes the funds more volatile. You never know in advance what the price will be when you want to sell.

Agree, you don't have the option of deciding to hold the bonds in a bond fund to maturity. The only bond fund I've ever held a significant amount of money in was a short-term tax-free municipal fund for my home state. The short term nature of the holdings limited share price fluctuation.

It may be time to reinvest in such a fund as we build savings outside retirement accounts.

 

[all4j]

I wanted to understand the difference between the SEC yield stated by bond funds & the dividend yield we receive. The SEC yield stated by the fund is average Yield to Maturity of the underlying securities.


Any comments/corrections are appreciated.

You may want to do some additional research into SEC yield as it is not the same as yield to maturity. I'm not sure exactly what your "dividend yield" is; most get confused between SEC yield & "distribution yield" in my experience. I will comment on those as there are misconceptions by some.

"Distribution yield" is not a standard term. In rough terms, it takes the previous 12 months into account. Since there isn't a standard definition, what is included & what isn't can vary between fund families. I'm not sure if it is still true, but at one time Vanguard & Fidelity calculated distribution yield differently.

The SEC stepped in to provide a standard -- the SEC yield. It's intent is to provide a means of comparing 2 funds at a point in time. Even including closed end funds etc. It looks at the most recent 30 days & somewhat assumes there won't be any changes. That is, assets held to maturity, etc.

Again, the intent is to be able to compare at a point in time. It was never intended to have predictive powers that some try to use it for. In the bond market we have now, the environment is sure to change & indeed has changed more in past year than past 30 days.

The definition of SEC yield can be found on the web if you should want to brush up on that.

 

[walkinwood]

All4j,


I deleted my message - I had a wrong understanding of SEC Yield. I think the spreadsheet shows some important information, but I need to rewrite my post.


Thanks for clarifying the terms for me. I meant distribution yield, not dividend yield.

 

[foxfirev5]

The being able to hold to maturity is the main advantage of bonds vs. bond fund in a rising rate environment. So of course if you ignore the main advantage you aren't going to see as much difference between the two. The lack of a maturity date is what makes the funds more volatile. You never know in advance what the price will be when you want to sell.

That's another reason why I have both. I have no idea when I want all of the money allocated to bonds. Some is used for LMP with ladders, meanwhile funds provide for rebalancing (timing) and liabilities beyond my 17 year ladder. The ladder should carry me to age 85. Beyond that, the reinvested dividends in the funds should provide growth and simplicity for whoever is left holding the assets. Bear in mind that the funds probably won't be sold all at once. Just the reverse of accumulation DCA.

Also, by using a LMP approach to maturing bonds I've eliminated reinvestment risk for this portion of my holdings. Sooner or later rates may fall and I don't want to deal with that with every maturing bond. I have no idea where rates are going and prefer not to play that game.

 

[Montecfo]

After spending the last 7 years creating a bond/CD ladder to cover future spending, I really don't see any difference between my ladder and my bond funds of similar maturity/duration. If I'm honest with myself I must look at the market value rather than the hold to maturity par value of the individual bonds. The % increase/decrease is nearly identical for the individual holdings vs funds.

Now that my bond ladder of CD's, Treasuries and TIPS is complete, all new FI reinvestments are going into a short term treasury fund and an intermediate term fund. Time to sit back and enjoy the ride. More importantly I don't want to leave anyone with a big mess of individual holdings when I'm no longer here.

This is not unexpected.

I have filled out my bond ladder to this point also, but some rungs ended up fatter than others and there is a missing rung or two as I have prioritized yield. But I have kept some fund holdings which have done well or have longterm records of doing so.

I will have a chunk of money for reinvestment next month and hope to fill in a rung or two so the climb is less strenuous. Meanwhile I do like the MM funds.

 

[Freedom56]

With rates rising and then leveling off later in 2023, those holding bond funds distributing 1.5%-2.5% cannot compete with new treasuries, CDs, and corporate bonds yielding 5%-6% or even MM funds yielding 4.5% and climbing. To believe otherwise, would imply that investors are willing assume more risk to earn less. That isn't rational and expecting a different outcome that what occurred in 2022 is also irrational. One would expect the redemptions to accelerated once again just like this time last year.

 

[walkinwood]

I created this spreadsheet to understand why the distribution yield of bond funds is lagging the prevalent interest rate for bonds with similar rating/maturity.

I used a ladder of 10 year treasuries and assumed that $1000 was purchased on the first trading day of each year. Data from the St. Louis Fed site.

In the latest year (2023), the yield to maturity of the individual bonds is the same as the yield on the current 10 yr treasury, but the distribution yield is much lower.


I'm no expert at this so would appreciate any comments.


I've attached the pdf. Here's a view only link to the spreadsheet on Google Sheets.



Note: In a previous (now deleted) post, I had wrongly assumed that the SEC yield was about the same as the YTM.

 

[surprising]

I am partially funding my early retirement with CEF bond funds. I also have about 33% of my 401K in various CEFs. I've held these through the last two shocks (pandemic and 2022) and they all paid their dividends, and none saw a dividend reduction. My average yield is 8%.
The stock prices can be pretty volatile but overall I've noticed they are less volatile than the market. However, they are still down quite a bit from highs due to interest rate hikes. But I am happy collecting my 8% on cost.

 

[COcheesehead]

I am partially funding my early retirement with CEF bond funds. I also have about 33% of my 401K in various CEFs. I've held these through the last two shocks (pandemic and 2022) and they all paid their dividends, and none saw a dividend reduction. My average yield is 8%.
The stock prices can be pretty volatile but overall I've noticed they are less volatile than the market. However, they are still down quite a bit from highs due to interest rate hikes. But I am happy collecting my 8% on cost.

I have a small allocation to bond like CEFs. I use PDI and PDO. They represent about 6% of my assets yet generate close to $40,000 in yearly income.
I am down in NAV in PDI, but up in PDO. PDI generates close to 13% and PDO about 11%. They are super volatile though. Some were down as much as 60% during the early pandemic. I consider these as very aggressive and I wouldn’t allocate anymore than I have right now.