This Is Why You Should Ditch Your Bond Funds And Buy Some Bonds Instead

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Bond funds took a hard hit this year, as interest rates climbed sharply – and are likely to keep rising. This is not just very bad news for bond fund holders; it contradicts the long-standing belief that equity portfolios can be effectively diversified with bond funds.

To be sure, bonds can still be excellent investments. It is just that bond funds are not good proxies for individual bonds – at least not in the same way equity funds are good proxies for individual equities. This is a crucial distinction that has big implications when it comes to the construction of an investment portfolio.

Bond funds are pools of individual bonds, in the form of ETFs (like the iShares AGG AGG , -12.5% YTD) or mutual funds (like Vanguard’s VBTLX, -12.7% YTD). Unlike equity funds, bond funds are very different from the assets they hold. While an individual bond has a periodic, fixed payment and a stated maturity date at which principal is repaid and the bond ceases to exist, bond funds operate in perpetuity and pay dividends that fluctuate over time. This means that while bond buyers receive a known yield when they buy a bond and hold it maturity, bond fund buyers have no way of knowing what total return they might receive in any given period.

Take, for instance, a simple bond fund like IEF IEF , the iShares U.S. Treasury 7-10 year ETF (-12.99% YTD). It contains 12 U.S. Treasury bonds maturing between 2029 and 2032. To maintain the 7-10 year range over time, the fund will periodically sell the bonds that fall short of the 7-year maturity and purchase bonds that are closer to 10 years. As interest rates rise and time passes, the fund will buy bonds at lower rates (higher prices) than when they sell them, sometime later, at higher rates (i.e at lower prices). That is, bond funds are forced to buy high and sell low.

This is stated explicitly in the methodology of leading fixed-income indices such as the Bloomberg U.S. Bond Aggregate family against which many bond funds are benchmarked. In their words,

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“There is usually a lengthening of an index’s duration each month due to cash and bonds that are being dropped from the index often having lower durations than the bonds that remain in or enter an index.”

With the Fed in a rate-hiking mission, bond funds are doomed to continue their money-losing record. This may be hard to accept for some market participants, because they have had a good run with bond for 40 years. Since 1982, the super-cycle of declining interest rates gave bond portfolio managers the built-in advantage of buying their fund constituents at low prices (high rates) and selling them at higher prices (lower rates). This trend is now starting to reverse, and is turning this process-driven bonanza into a curse.

Even a supposedly safe fund such as SHY SHY (the iShares 1-3 year Treasury Bond ETF) had a negative total return of -3.75% in the six months since the end of 2021. At that time, a 6-month U.S. Treasury bill had a 0.2% yield, thus yielding 4% better performance (or, roughly, 8% annualized) than the supposedly ultra-conservative short-term fund. SHY is unlikely to do much better in the next six months, which makes the 2.4% yield on U.S treasuries maturing in December sound positively juicy in comparison.

This, however, does not mean that investors should avoid bonds. Individual bonds can still provide excellent diversification and decent returns to offset losses in equity portfolios. This will not be an easy transition for many.

A good number of retail investors perceive the bond market to be complex and opaque – understandably so. The bond market is huge: $53T in the U.S. at the end of 2021, according to SIFMA. But it is atomized into tens of thousands of bonds. Just the U.S. Treasury market alone includes 181 T-bills, 118 T-notes, 115 T-bonds, 152 TIPs and 114 Floating-rate notes, among many other securities. There are also municipal bonds, agency bonds, and corporate bonds of financial institutions like Citigroup C and non-financial corporations such as Boeing BA . A service for clients of Charles Schwab & Co. called BondSource claims that it gives investors access to “over 60,000 bonds.”

Many of them are quite illiquid because of their small size; some are bought as soon as they are issued and then buried in portfolios until maturity. In addition to the overwhelming numbers of bonds outstanding, they can be complex, usually coming with call features, “make-whole” provisions, minimum lot sizes, changing ratings, etc.

Because of these hurdles, investors may find that they need the help of an advisor to find the bonds that are most appropriate for their situation, and they should do that sooner rather than later if interest rates continue to rise, as it is widely expected.

The crucial point when investing in individual bonds is that they must be held to maturity to receive the promised yield. Otherwise, they confront the same problem as bond funds: uncertainty about the exit value, liquidity risks and high vulnerability to rising rates.

Good opportunities are available for investors ready to accept some credit risk. As an example, Royal Bank of Scotland’s 6.125% bond due on 12/15/2022 recently traded with a yield-to-maturity of 3.4%. While its credit rating is far lower than that of the United States, an investor that thinks that it is unlikely that RBS could default on its obligations within the next 6 months would be much better off with that bond than with bond funds, which are at high risk of losing money as rates go up.

Investors should understand that bond funds and individual bonds are fundamentally different instruments, unlike equity funds and individual stocks which share many investment characteristics. With rising rates, individual bonds held to maturity are poised to deliver a much better performance than bond funds held for similar periods. The case for switching out of bond funds and into individual bonds at this time is strong for those who seek effective diversification against equity positions.