Bonds vs. Bond ETFs

I have been wrestling with the question of whether it is better for the retail investor to buy bonds directly or bond exchange-traded funds (ETFs). At this stage, I’m leaning toward bond ETFs as the best way to go for long-term horizons (e.g. retirement funds). Let me throw out some thoughts why. If anyone sees any flaws, let me know before I plunk some money down.

Let’s summarize what the proponents of direct ownership claim:

• individual bonds have maturity dates and offer certainty of returns if held to maturity, unlike bond ETFs

• commissions and management expense ratios (MERs) make bond ETFs more expensive than the commission paid to buy bonds over the counter from dealers.

OK, what to make of this. The first thing to get out of the way is how to do the comparison. Comparing a bond ETF to a single bond doesn’t fly with me. The bond ETF is diversified in terms of default and interest-rate risk, which is good. A single bond is not diversified on those criteria, which is not good. So the comparison, it seems to me, should be between the bond ETF and a diversified ladder of bonds (1).

Now, if you look at bond ladders in use for long-term investing, most seem to be the rolling kind – i.e. maturing bonds are rolled into new bonds. So, the cost of owning bonds directly is not just the commission paid when they are first bought but also the commissions paid on rolling them. The costs of direct ownership would then seem to be more in line with bond ETFs, especially considering over-the-counter commissions are high in percentage terms (particularly for strip bonds).

In addition, a rolling ladder has no fixed maturity date and is subject to the same uncertainty of returns as the bond ETF. It is only when the ladder matures into cash that it offers certainty of returns (2) (3). There is a good discussion of these points, and the equivalency of bond ETFs and rolling bond ladders on the Boglehead Wiki.

Other reasons to prefer bond ETFs:

Another consideration is that it is hard to construct a diversified bond ladder with less than $75,000 or so. Small investors don’t seem to have much of a choice other than bond ETFs. An exception might perhaps be if the retail investor only went with government bonds: since default risk is low, the ladder would not have to be too big.

Yet another consideration: the convenience of owning bond ETFs. From the excellent summary on the HowToInvestOnline blog, we have:

• it’s easier to rebalance a portfolio with bond ETFs
• reinvestment of interest payments is easier with bond funds (not a concern for ladders of strip bonds, though)
• running a bond ladder is more work than owning a bond fund, e.g. got to assess bond issuer’s creditworthiness (except in case of government bonds)

Notes:

1) A bond ladder spreads a sum of money over bonds of different maturities. An example is $100,000 divided equally over 10 bonds maturing in 1, 2, 3, 4, 5, 6, 7, 8, 9 and 10 years.

2) When the time approaches for taking cash out of a bond ETF, certainty of returns can be had by selling the ETF in parts and putting the proceeds into bonds that mature on the dates needed.

3) Perhaps one exception where a bond ladder might be better than a bond ETF over the long run is for those investors saving for retirement through a non-rolling ladder of inflation-indexed bonds, as Professor Zvi Bodie advocates for conservative investors. In Canada, inflation-indexed bonds are known as real-return bonds and in the U.S., as Treasury Inflation Protected Securities (TIPS).

Comments

[dieuwer]

I suggest TreasuryDirect

2009 Nov 25 12:31 PM

[michael rothschild]

i built my retirement fund by investing 100% of my portfolio in treasuries, gnma and gov. agency mortage backed securities.
i have owned corporate bonds, but i always sell them when the price appreciates 7%, even if i miss an interest payment.
zero coupon bonds (strips) should ONLY be purchased when interest rates are high,when rates drop they work like TBT only your gain will be for example- 30% if rates drop 1 %
i made a ton of money in the 80s and up until about 1996.
but obviously those days of interest rate cycles are gone and unlikely to reappear in the next decade.
laddering is for the birds,its a scam made up by wall street.
you cannot get a good return on bonds at this time,so either sit on your cash or buy TBT if the bond market rallies below 4% on the long bond.
ginnie maes and agency mortage backed securites have also dissapeared for the most part.
depending on what type of brokerage account you have you may be able to buy bits and pieces of "on the run" secondary market MBS.
i like them because they generate a monthly cash flow of interest and return of principal, which works much better than a ladder.
although i have been 100% in bonds for almost 30 years i have had to switch to telecom stocks with high dividends like WIN,FTR etc.
be warned-if you buy bonds now,and rates go up,which is likely over the next 5 years,the market value of your bonds will drop dramatically!
i still have gnmas i bought in the 90s that pay me 13% (they were issued in 1984) i bought 20k and all of the principal has still not been returned!
sadly, those kinds of opportunities no longer exist.
i would not buy a bond or bond etf of any type at this time,
i think it is one of the most risky investments you can make

2009 Nov 25 01:12 PM

[mbkelly75]

I replaced Bond Ladders with Bond ETFs when the ETFs came out and have never had a reason to feel bad about doing it. Good article that makes it's point clearly and understandably. Thank you for your work.

2009 Nov 25 04:55 PM

[User 488294]

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2009 Nov 26 11:53 AM

[User 41525]

Won't the ETF value go down as rates go up, so you can never be sure where that will stop as rates go up?

2009 Nov 26 02:14 PM

[Old Trader]

Mr. MacDonald,

I'm glad you brought up the diversification issue, which I think is a fairly important one. Months ago, I had a small dialog, here on SA, with another poster about direct bond ownership vs. bond ETFs, and my back of the envelope calculations also showed that somewhere in the neighborhood of $75-$100k would be needed to put together a reasonably diversified bond allocation. (Note: I claim no particular expertise in fixed income analysis).

A question...rather than rolling over bonds, what are your thoughts on holding to maturity, which, under certain conditions, could add capital appreciation to yield, assuming bonds were bought in the secondary market, rather than new issuance?

2009 Nov 27 12:04 AM

[PompanoFrog]

As a retired owner of stock brokerage firm I was/am appalled at the spread bonds trade at for the retail investor. In periods of stress the spreads are in excess of 7-9%. This makes bond etf's to be the superior vehicle.

2009 Nov 29 03:29 PM