Financial Opinion and Insights

Why Would Anyone Buy A Bond Fund?

IFG BlogThat’s a question a few professionals have asked, including Fidelity’s star former manager, Peter Lynch, in his book One Up On Wall Street.    It’s a valid question, too.  Individual bonds do have some advantages:

  • Individual bonds have a maturity date.  Regardless of market swings and valuation changes, you know what your bonds will be worth on their respective maturity dates.  So, if you’ve ‘laddered’ intermediate bonds, you know each will mature at face value – a strategy that can provide some comfort, since it can alleviate concern over valuation changes prior to maturity. 
  • Gains are realized only when taken, which is true for virtually all individual securities in taxable accounts.  A mutual fund, however, is a ‘pooled money’ vehicle.  When a fund takes a gain on a position, you pay your share of the freight on the fund portfolio’s entire gain for that position, even if you’d been a shareholder for only a day!  The reason:  you didn’t’ own that security; the fund did, and you are a shareholder in the fund, not the position.
  • Direct ownership can lessen the impact of other investor trades.  Think of it this way:  When – I say `when’ because it’s bound to happen at some point – interest rates begin to rise, bond values will begin to decline.  As those values – the fund prices investors see on their statements – begin to fall, you can expect many bond fund investors to begin selling their shares.  When they do, fund managers are forced to sell-off bond positions to raise money in order to meet redemption requests from selling shareholders.   That means they’d be selling when prices are heading lower… the very time they’d likely rather be buying!   When fund managers sell-off with block trades, common sense tells you there has to be a ‘market impact’ cost attached.  Owners of individual bonds aren’t forced to sell due to market swings when their purchases were made with a maturity date in mind because, as we said earlier, those bonds will mature at face on a date certain.

So, if individual bonds seem to offer some distinct advantages, do bond funds ever make sense in a portfolio?  You could probably ask ten different advisors and get ten different answers; so, for what it’s worth, my humble opinion is as follows:

While there is some obvious knowledge, skill, and talent attached to the selection of and management of domestic and foreign bonds, in terms of credit quality, etc., particularly where longer maturities are involved, most serious individual investors aren’t trying to beat the bond markets.  Their larger concerns revolve around either dependable income, risk mitigation, or some combination of the two.  

For the most part, particularly when it comes to what individual investors care about, bonds are what they are.  A Treasury is a Treasury.  For dependable income and risk mitigation, it’s hard to beat owning bonds directly.   But, for most people trying to achieve long-term goals, there is one alternative worth consideration in certain types of accounts.

While you might continue to use individual bonds in taxable accounts for reasons cited above, you may want to consider some sort of low-cost pooled vehicle in your tax-deferred accounts, i.e., 401(k)s, IRAs, etc.   The reason is simple:  It’s hard to rebalance your overall asset allocation with individual bonds.   Who wants to sell-off individual bonds and rebalance into equity or vice-versa?  It’s cumbersome and can be quite costly.  There’s an old saying in the bond market:  Buyers buy the market and sellers pay the freight.  There’s a better way:  Usef low-cost, no-load bond index funds or exchange-traded funds (ETFs) to fill-out your bond allocation and provide an easier vehicle for periodic rebalancing.  Costs are low; you’re in a tax-deferred vehicle; and you’re managing more efficiently for risk mitigation.


Jim Lorenzen, CFP®, AIF®Jim Lorenzen is a Certified Financial Planner® and an Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors. Plan sponsors can sign-up for Retirement Plan Insights here.  IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.  Additional resources:   IFG Investment Blog. Retirement Plan Insights Archive.

Twitter:  @JimLorenzen.

Written by Jim Lorenzen, CFP®, AIF®

May 22, 2012 at 8:00 am