Bonds vs. Bond Funds

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For investors bonds can appear to be complex. So, oftentimes people opt to buy bond funds in an attempt to quickly diversify their portfolio.

The chief advantage of a bond fund is its convenience. You let someone else do the work for you. But, the key question is, what do you give up in exchange? 

The disadvantage of a bond fund is that it’s not a bond; it has neither a fixed yield nor a contractual obligation to give investors back their principal at some later maturity date—the two chief characteristics of individual bonds. Because managers constantly trade their positions, the risk-return profile of a bond fund investment is continually changing. Unlike an actual bond, whose risk level declines the longer it is held by an investor, a fund can increase or decrease its risk exposure at the whim of the manager. Since a bond fund has no fixed rate and a fluctuating maturity range you have no control over the cash flow you will receive from the fund.

The big thing about building your own portfolio is that you can tailor it to meet your circumstances, meaning all bonds will mature precisely when you need them. A bond fund cannot deliver that sort of precision. If you construct your own portfolio you have far greater control over determining the maturity and cash flow of your fixed income portfolio.

Constructing a Portfolio for Your Specific Needs

How can fixed income investors achieve a respectable rate-of-return without experiencing the higher risk associated with the fluctuation of interest rates? Before we get too far into this let’s cover a couple of things. The values of bonds move in the opposite direction of interest rates. In general, as rates rise bond values will fall. Declining interest rates will help boost the value of bonds. Another thing we need to consider is reinvestment rate risk. If interest rates fall we will reinvest proceeds of maturing bonds at lower yields. The opposite is true if rates rise.

What is an adequate tradeoff of higher risk for higher return? This is where a laddered bond portfolio comes in.

Laddering is a way of building a portfolio of bonds with staggered maturities so that a portion of the portfolio will mature each year, or whenever it is you want them to mature. To maintain the ladder, money that comes in from currently maturing bonds is typically invested in bonds with longer maturities within the range of the ladder.

Laddering accomplishes two important goals:

  • Captures price appreciation as the bonds age and their remaining life shortens.
  • Reinvests principal from maturing short term bonds (lower yielding bonds) into new longer-term bonds (high yielding bonds).

What Happens If Interest Rates Fall?

Initially the portfolio's return rises in value as bond prices get marked up. Ultimately, as those bonds mature and proceeds are reinvested in lower-yielding bonds the portfolio’s long-term return is slightly lower than it would have been in a stable rate environment. The income stream will slightly decrease, but only gradually because the longer-term higher yielding bonds continue to be held in the portfolio and the income generated continues to be the average of all the bonds.

What Happens If Interest Rates Rise?

Remember bond values and interest rates move in the opposite direction. Let’s look at the impact of rising interest rates on a laddered portfolio. Your portfolio will have bonds with various maturity dates. The bonds closest to maturity will have the least amount of risk and will be the least impacted by rising rates. They will likely suffer a small price decline and recover that decline as they move toward maturity where you will receive the face value of your investment. The built-in reinvestment feature of the laddered portfolio works to offset some of the price depreciation of your portfolio. As shorter term bonds mature you will reinvest those proceeds at higher rates. The longer-term bonds in your portfolio will see their values decline as rates rise but again that decline will be manageable because a rise in near term interest rates will not have that large of an impact on the longer maturity (higher yielding) bonds.

The laddering strategy makes sense. It reduces interest rate risk because it shortens the average maturity of a portfolio resulting in less price sensitivity to changing interest rates. This strategy also smooths out reinvestment rate risk since money is being reinvested continuously throughout a full interest rate cycle. The end result is a portfolio with returns close to those of long term bonds but with substantially less risk. 

Regardless of the direction of interest rates, you can generate attractive long-term risk adjusted returns employing a laddered portfolio strategy. With a laddered portfolio you can generate a cash flow stream that is far more predictable than what you will receive from a bond fund. Since you determine the average maturity of your individual portfolio you gain far greater control in managing price fluctuations in response to changing interest rates with a laddered portfolio.

Examples

For the Investment Grade Corporate Bond Fund (LQD) and iShares Barclays 20+ Year Treasury Bond Fund (TLT) shown below, you can see a large part of the problem with funds. The growth in your dividend has been negative and the dollar amount you have received has decreased over the past several years. You lack control over the maturity of the holdings in the funds. There is no way to plan for the cash flow you will receive over the years. With a laddered portfolio only a small portion of your portfolio would be maturing in any one year. The bulk of your portfolio will not be maturing and you will have greater control of the cash flow you are expected to receive.

lqd corporate bond fund
Source: Bloomberg

tlt treasury bond fund
Source: Bloomberg

This last chart shows the performance of two very popular bond funds. The shaded portions show the performance of the funds during periods of rising interest rates. With no stated maturity for the funds, prices can fall substantially when interest rates rise. With no fixed maturity increases, interest rates can have a materially negative impact on the value of the fund. You do not have as much control over the process of capturing bond appreciation as bonds age and their remaining life shortens. With a laddered portfolio the short to intermediate term portion of your portfolio will be largely immune to rising interest rates since they are closer to maturity.  You will take the proceeds from maturing bonds and reinvest them at higher interest rates and actually smooth out the effects of rising rates. You have greater control over your portfolio because you control the maturity levels of your portfolio.

bond fund performance
Source: Bloomberg

If you'd like any more information on how to construct a bond portfolio as described above, please feel free to contact us at (888) 486-3939.

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About Thomas J Smith CFA

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