Why Bond Mutual Funds Are Not A Replacement For Individual Bonds

During the time I was writing this, I was interviewed for a podcast in which I discussed this very topic. To listen, click here.

For most of the last two decades, bond mutual funds were an easy and convenient way to purchase bonds. However, as rates fall, you are getting diluted by new money flowing into the fund and reducing your yield.

What the heck is he talking about?

I’ll explain! It’s actually very simple. By purchasing individual bonds, we can provide you with massive outperformance for the next five, and ten years and beyond. Okay, let’s walk through it.

First off, for most of the time period since 1982, interest rates have been falling. Many of you baby boomers can recall interest rates on your homes in the teens.

Those rates bottomed out during Covid with the 10-year yield hitting 0.32%¹, down from nearly 17% forty years prior. Since Covid, rates have been moving higher. That’s especially the case in the last 18 months after inflation has flared up.

_{^{Source: YCharts, as of 06/21/2023. Graph illustrating 10 year Treasury Rate.}}

The mechanics are important. A mutual fund is just a pool of hundreds of individual bonds. However, mutual fund companies love to fool people into thinking that bond funds are the same as owning individual bonds. The differences in risks and exposures are very often overlooked.

An individual bond is a loan. The issuer, let’s use Apple Inc in our example, issues new bonds to finance their operations. They are the borrower and you the lender as the bond buyer. Apple pays you interest for the privilege of borrowing from you, called the coupon. [Many decades ago, the bonds had actual coupons on them that you had to cut off and send in for the interest].

However, the biggest difference, and benefit, for owning individual bonds is that there is a terminal date. This is a date when Apple must pay back the original loan from you. This is called the maturity date.

That maturity date provides a key advantage- especially in this environment.

Back to the mutual fund though. A mutual fund is a perpetual “investment company” that never matures. The hundreds, sometimes thousands of bonds it owns can have varying maturity dates. When one bond matures, they reinvest the bond proceeds into new bonds. This is the key difference.

Last year, bonds fell by the most amount ever. Before 2022, the worst year ever for bonds was 1994 when the index fell by -3.9%.² Last year, the bond index fell by -13.02%, three and a half times the prior worst year ever.

How Bond Prices Move as Maturity Nears

The good news is that the year after every poor year for bonds tends to be one of the best years. That’s because of that terminal rate. As a bond closes in on the maturity date, the price rises towards “par” or $100. Bonds that mature in the next year or so won’t see much price movement because they are so close to maturity (and the bondholder getting back $100). As long as the bond does not default, you are for sure getting your principal back. The image below shows that relationship. As the price gets closer to the maturity date, it is “pulled” towards par.

_{^{Source: Insight Investment, data as of 06/21/2023. Graph illustrating Pull to Par over time.}} 

Think about that for a moment. If you knew you were getting back $100 on January 1^st, 2024, the price of the bond couldn’t be much below $95, or the investor would be realizing a large return (that would be about 13% annualized).

However, a bond that doesn’t mature for a long time has more sensitivity to rates since that maturity date isn’t much of a factor as the above image shows.

The Main Problem with Bond Funds

Equity funds behave like a basket of individual stocks, but a bond fund behaves nothing like an individual bond.

1. An individual bond fluctuates with interest rates, but those price fluctuations decrease considerably as the bond approaches maturity – as we just detailed – since there is no uncertainty as to what you will receive and when you will receive it.
2. Conversely, a bond fund, or a pool of bonds, will consistently move with interest rates since there are so many bonds and bonds that mature get reinvested into new bonds. There is no set maturity but a perpetual motion machine of reinvestment.

The other problem is the potential path of interest rates. Bond funds can take in new capital from investors every day. If I want to invest in ABC Bond Fund, I can make that purchase up to 1 minute before market close and get that day’s price. The bond fund manager then takes that investment and buys new bonds.

Here is the rub. If rates fall, and bond funds get new capital (which they will), those new dollars will be invested at lower rates. Even if you invested in the fund when rates were much higher, you will be diluted by those new investments, lowering your yield.

Eventually, the mutual fund will simply yield what new bonds are yielding in the market. In other words, you will NOT LOCK IN the current yields in the bond market for very long.

Individual bonds do not have that problem since they are fixed investments. The coupons stay the same until maturity. So, we at Noble Wealth are focusing on what’s best for clients: individual bonds.

Most advisors don’t want to bother with individual bonds because they are much more work. They buy bond funds as a replacement just as they do when they do not want to buy individual stocks.. However, as we laid out above, they are not a substitute for individual bonds.

Don’t get me wrong. For most of the last two decades, bond funds provided easy access to bonds. It is only in the last five years or so that individual retail investors could even purchase individual bonds electronically. Prior to that, they would have had to call up Fidelity, Vanguard, Schwab, or Merrill and have them call other banks to locate the bonds on their behalf. It was a costly and time-consuming process. However, environments change, technology advances, and advisors need to recognize and adapt to those changes and do what’s best for their clients.

We continue to shift portfolios over towards individual bonds in order to lock in the current, anomalous yields available in the marketplace.

As always, we value the confidence you place in us.

Mark J. Asaro, CFA

Noble Wealth Management

_{^{1 https://www.cnbc.com/2020/03/09/10-year-treasury-yield-plunges.html}}

_{^{2 https://www.cnbc.com/2023/01/07/2022-was-the-worst-ever-year-for-us-bonds-how-to-position-for-2023.html}}