Bonds vs. Bond Funds [Retiree Portfolios] September 5, 2000

Retiree Portfolio Bonds vs. Bond Funds

When it comes to the fixed-income portion of their portfolios, retirees have a choice: individual bonds or bond funds. For many investors, bond funds make sense, due to their convenience and diversification. However, there are many reasons why individual bonds are preferable. Primarily, they provide a fixed rate of return, and a return of an investor's principal. Those are promises that bond funds just can't make.

By Robert Brokamp (TMF Bro)
September 5, 2000

The Retiree Portfolio is unique among The Motley Fool's real-money portfolios. Not only is it the only portfolio with bonds, it invests in them through mutual funds. For many investors, bond funds make sense. They're easy, diversified, and -- if chosen properly -- cost-efficient. However, just because a Fool portfolio holds bond mutual funds doesn't mean they are always the best choice over individual bonds.

Meet Betty, a retiree who prefers individual bonds. On Saturday mornings, after fiddling with the engine of her convertible Mustang, she likes to take a walk with her neighbor, Fred. He is also a retiree, but the fixed-income portion of his portfolio is in mutual funds. In fact, that's what everyone says about him. "That Fred sure is a real fund guy."

During their walks (which sometimes lead them to the beach, other times to the park, occasionally to a monster truck rally), they often discuss money. They've found that they're both looking for stable, safe income from their fixed-income investments. However, their respective choices have led to significantly different consequences. Those differences can be broken down into five categories.

1) The "fixed income"
Betty recently invested $10,000 in corporate bonds that will pay 7% a year for the next seven years. Like most bonds, the interest is paid semiannually. Thus, she'll receive two payments a year of $350 each. She can plan on this, and budget accordingly.

On the same day, Fred put $10,000 in the Hideyhole Intermediate-term Corporate Bond Mutual Fund, which pays a monthly dividend (as most fixed-income funds do). Its yield is currently around 7%.

However, the "fixed income" of a bond fund is not fixed. The dividend changes, depending on the bonds the fund manager has bought or sold, and the prevailing interest rates. Fred doesn't know exactly how much he'll receive from month to month.

2) Principal
On the day that Betty's bond matures, she will receive $10,350: the $10,000 she originally invested, and the last interest payment. She knows beforehand when this will happen, and can plan accordingly.

As for Fred, he won't know how much his initial investment will be worth in seven years, or even seven weeks. That's because the net asset value (NAV) of the fund (i.e., the price of each share of the fund) changes daily, again depending on the bonds in the fund and interest rate fluctuations.

Bond funds do not mature. Unlike individual bonds, bond funds do not have a contractual obligation to return an investor's principal.

3) Costs
Betty -- whom Fred affectionately refers to as "The Bond Bombshell" -- bought her bonds through a discount broker. She paid $50 in commissions.

Fred -- whom Betty calls "Elmer Fund" -- pays an annual expense ratio, as do all mutual fund investors. His fund charges 0.77% per year, which is about average for a bond fund. That means that his share of the expenses to run the fund is $77 a year. In seven years, when Betty's bonds matures, her costs still will have been $50. Over those seven years, Fred will pay $539 -- assuming, for simplicity's sake, that the fund's NAV doesn't change, which is unlikely.

Fred did make sure to buy a no-load fund (i.e., a fund that doesn't charge a sales commission). Had he chosen a fund that charged a 3% load, for example, his costs would have risen by $300, plus there would be $300 less of his principal to earn interest.

4) Capital gains
The only way Betty would pay capital gains taxes is if she sold her bonds before they mature and she received more than $10,000 for the sale.

There are two ways Fred would have to pay capital gains taxes. First, like Betty, Fred will have a gain if he sells his investment for more than he paid. Since the value of his investment when he sells will most likely not be $10,000 (his initial investment), he will have a capital gain or a capital loss.

Secondly, if the fund manager sells a bond for more than it's worth, that capital gain will get passed on to Fred and his fellow shareholders. This happens every year to mutual fund investors. Managers buy and sell securities all year long, incurring capital gains and losses along the way. Even if the fund distributes tax-advantaged income -- from investments in Treasuries or municipal bonds -- the capital gains are still taxable.

5) Knowing the investment
Betty knows what she bought. She knows which company issued the bonds, and its credit rating. Her $10,000 is fully invested in those bonds.

As for Fred, he knows that he invested in an intermediate-term corporate bond fund, but he doesn't know which companies issued those bonds, or their credit ratings. The fund does publish a semi-annual report, but that's just a one-day snapshot of the fund. His fund has a turnover rate of 150%, which is about average for bond funds. That means that, in the course of a year, the fund manager has sold all the bonds that were in the fund at the start of the year, and has disposed of half of the second batch of bonds, too. Plus, the fund is never fully invested, because a portion of the fund must be kept in cash to meet administrative needs and redemptions.

(In fact, Fred read a SmartMoney article that made him a little nervous. It pointed out that the Securities and Exchange Commission requires a fund to have only 65% of its assets invested according to its stated objective. The article cited the Strong Government Securities fund as an example, pointing out that 14.5% of its assets were actually in corporate bonds.)

Both sides of the fence, and common ground
When Betty and Fred get in a really heated discussion of bonds -- as we all do -- their arguments boil down to these.

Betty: "Retirees buy bonds for stable, reliable income, and they want to know that they'll get their principal back. You don't get that with bond funds, and you pay ongoing expenses and maybe capital gains to boot."

Fred: "Well, you put all your faith in a handful of companies. What if one of those companies defaults, or goes bankrupt? I've diversified by investing in a fund that owns hundreds of bonds; if one or two of the issuers go belly up, I won't lose my shirt. As for costs, I read an article on arguing that low-cost funds are more cost-efficient for fixed-income portfolios of $50,000 or less."

There are two things Betty and Fred agree on. First, there aren't many good reasons to buy Treasury bond funds. U.S. government securities can be bought from Treasury Direct, commission-free. Because Treasuries are so safe, there's no need to pay an expense ratio (or worse, a load) for the diversification.

Finally, Betty and Fred agree that the "bond vs. bond fund" dilemma is an individual choice that should be made after thorough research -- and then forgotten to make more time for monster truck rallies.

Related Links:

  • Investing Basics: Bonds, Fool's School
  • Individual Bonds or Bond Mutual Funds?
  • Bond Funds: Treadmill to Oblivion? (speech by Vanguard founder John Bogle)
  • 10 Things Your Broker Won't Tell You About Bonds,