Bonds and Bond Funds

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There is a question that often comes up when discussing investment strategies, especially for an astute investor who has done some research on various kinds of investments. Specifically the question often is: why would we choose a bond fund or a bond index fund versus purchasing a specific bond (or several bonds)?

Bonds in General

To answer the question, we have to start with a basic understanding of bonds in general. A bond is a loan – either to a corporation, the US government (or a foreign government), a state, or a municipality, among others. For this loan there are very specific terms, which include:  maturity of the bond (how long it exists), the coupon rate (what amount of income it provides), whether the bond is “callable” – meaning, if circumstances change and the issuer wants to pay off your bond early, is that allowed?

If you had a bond with a corporation that was worth $1,000, had a maturity of 30 years, and pays you $60 every year, your yield is 6% ($60 divided by $1,000). Here’s where it starts to get complicated though:  when you purchased the bond, you likely didn’t purchase it for $1,000 – the purchase price is discounted due to the fact that you won’t get your money back for 30 years, so the price might have been something like $900.

If nothing changes, you will receive your annual $60 payment for the next 30 years, and then you’ll receive the $1,000 value of the bond. However (and there’s always a however in life, right?), if you decided after 15 years that you wanted to get your money out of the bond, you would sell it on the secondary market – but not likely for $1,000, or even for the $900 that you paid. If nothing else has changed (current rates are the same, credit risk of the corporation is the same, etc.) then this bond is likely worth somewhere between your purchase price and the redemption value of $1,000.

If other things have changed, this bond could be worth much more than the $1,000 or much less than the $900 that you paid. Let’s say that interest rates had dropped off for new issues of similar bonds, to a new rate of 3%. Obviously your locked-in 6% is worth much more to a new investor coming to the market, so your bond might bring $1,100. Vice versa is true if rates had climbed – your bond could be worth less than you paid for it. In either case, if you don’t sell the bond, at maturity it will still be worth $1,000, the face value.

Likewise, if the company that issued the bond was facing hard times and their creditworthiness was in question, the value of the bond would decrease to reflect this situation, and vice versa if things had improved for them.

Adding to this, if the bond happens to be callable (which many are), if a situation arose wherein the company could obtain loans at a more favorable rate after, say, 18 months of your purchase, they would pay you the value of the bond and end your loan with them. This would leave you having to purchase another bond at the new, prevailing lower rates.

Bond Funds

So, armed with the knowledge of individual bonds, we can now define a bond fund. A bond fund is an investment vehicle that owns many bonds. There are many types of bond funds, some defined by the maturity (or duration, a term related to maturity), some defined by creditworthiness of the bond issuers, and others defined by the governmental entity that issues the bonds. We won’t get into specifically discussing all these types of funds at present, just suffice it to say that all of these types (and many more) exist.

Since a bond fund holds many bonds, the result that the bond fund receives is the aggregate of all of the bonds it is holding. So, if the majority of the bonds in the fund are experiencing price increases (perhaps due to a market-wide decrease in rates for new bonds), then the price of the fund will increase.  If nothing changes, the yield for the fund (in dollar terms) will remain the same.

But most bond mutual fund managers are constantly buying and selling their holdings. One bond may show a hefty increase in value, prompting the manager to sell it for a gain, replacing it with a less-costly bond that achieves a similar yield. Or maybe the manager is looking to the future and believes that a particular bond’s value could increase due to circumstances that will improve the creditworthiness of the issuer, and so the manager might purchase that bond.

All this buying and selling make the contents of a bond fund fluctuate quite a bit over time, but the manager always pays close attention to the price of shares in his fund – if not enough new money is flowing into the fund to maintain the present price level, the manager may take some moves with his holdings that have the effect of keeping his fund’s price stable or growing slightly. If a major event occurred that the manager didn’t foresee, such as a dramatic market-wide increase in rates for new bonds, the price value of his fund could drop – or vice versa for a drop in rates for new bonds.

Bond managers are always managing their fund to maintain a stable price level and yield, but they can’t always make the right predictions. Sometimes the value of a fund will drop off because the manager misinterpreted some signal on the forefront, or a major holding in the fund declines in creditworthiness.

Bond Index Funds

Bond index funds aren’t managed actively, but rather (like all index funds) they track a specific index, and as such hold bonds representative of that index. When the index’s makeup changes (bonds are added or removed), the index automatically makes those changes. This takes the decision-making process out of the fund, so a fund manager won’t make a mistake (or a big winner) decision that results in a dramatic drop-off in value (or a dramatic rise in value).

So, if you are holding a bond index that always invests in medium-term bonds (maturity of 5-7 years), the bonds in the index will be constantly changing as bonds mature and new bonds are added to the mix. But in general you’ll experience much less volatility with the index fund, as you are taking that “forecasting” risk out of the picture.

An example of the “steadiness” or lack of volatility in a bond index can be seen with the Vanguard Total Bond Market Index (VBMFX). Over the many years of this index fund’s existence, the price has fluctuated from a low of $8.92 (the only time this fund was ever below $9, in 1987) to a recent high of $11.78. This fund fluctuated approximately 25 to 30 cents on either side of the $10 range up until about 2010, and over the past 10+ years has fluctuated about 75-80 cents on either side of $11. All the while providing a steady 3% to 4% yield annualized over the past 10 years.

Risks Associated with Bonds

Credit Risk. The issuing entity, whether it’s a corporation or a governmental entity, brings the risk that they could go bankrupt. With governmental entities this is less common, but it still occurs… and actually going bankrupt isn’t the whole risk, either. As the ratings agencies (Moody’s and Standard & Poors, primarily) review the issuing entity’s results and earnings forecasts, the rating of the bond can be changed. As this rating changes, the value of the bond may decrease or increase, depending upon which way the rating changed, since a new buyer of the bond may be more or less inclined to want to purchase the newly-rated bond.

Interest Rate Risk. I mentioned this earlier, but this is the situation where the bond you hold has a rate of, for example, 5%, and the rates on new bonds is higher, perhaps 6%. This would cause the value of the bond you’re holding to drop. This isn’t a problem if you plan to hold the bond to maturity, but if you need to cash it in early, you might lose money on the deal. Of course, on the other end of the spectrum, if the rates on new bonds decreased to 4%, your bond would be worth more if you cashed it in. But again, this situation might also subject your bond to be called by the issuer, leaving you in a lurch with no bond.

Inflation Risk. This is similar to interest rate risk, except that this is where general economic growth might cause the value of your bond to decrease. If inflation picked up to a point where your bond was only just keeping pace with inflation (such as a 4% bond and inflation at 4%), then of course new bonds being issued would have a higher rate, and as such your bond’s value would drop. Again, not a problem if you’re holding the bond to maturity, but would be a problem if you needed to cash it in early.

Characteristics of Bonds, Bond Funds, and Bond Index Funds

The chart below describes the major characteristics of individual bonds, managed bond funds, and bond index funds. Hopefully this will help you to understand the benefits of one type of bond investing versus the others for your individual situation.

The Bottom Line

So, we started this discussion to answer a question: why would you choose a bond fund or an index bond fund over investing in an individual bond? Hopefully discussion above has helped you to understand the benefits of one type of investment over another. The bottom line for me is – unless you have a pretty large sum of money to invest in bonds, in excess of a couple hundred thousand dollars, it costs an awful lot of time and money to build, diversify, and manage a portfolio of individual bonds. There is one important overriding factor that may cause some wary investors to choose individual bonds: the principal guarantee at maturity.

The convenience of mutual funds for their low entry point, instant diversification, reinvestment of dividends, and moderately stable value makes the choice pretty simple for most folks. Managing individual bonds is cumbersome, can be costly, and can cause liquidity problems (depending upon the term of the bonds).

Indexed bond funds reduce the volatility associated with managed bond funds, plus they generally have the lowest overall cost structure of all options out there (especially ETFs). It is for this reason that index bond funds are the overall best choice for most investors, and therefore index funds and ETFs are the bond investment option that I most often recommend.