Should You Invest In Bonds Or Bond Funds?

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Includes: BIL, DFVL, DFVS, DLBL, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, FTT, GBIL, GOVT, GSY, HYDD, IEF, IEI, ITE, PLW, PST, RISE, SCHO, SCHR, SHV, SHY, SPTL, SPTS, TAPR, TBF, TBT, TBX, TLH, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UST, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: EB Investor

Summary

Bond funds in all of their forms bring unnecessary risks into the portfolio.

There is nothing that beats the profit potential and long-term security of individual bonds.

It is important that investors do not turn safe investments into risky investments.

There is a debate swirling around the financial services universe: should investors invest in bonds or bond funds? Do they really need bonds at all? These are the main questions every advisor and investor is hearing or considering in the current low yield environment. But it is important to understand the purposes of each asset class within a portfolio. Equities provide investors with needed growth and exposure to the global economy. Bonds provide investors with preservation of principal and a dependable rate of income. The bond allocation represents a part of your portfolio that is secure from the ups and downs of the market when held to maturity.

So, yes, you need bonds, and you should choose individual U.S. Treasury securities over any type of bond fund. In this piece I will lay out my reasoning, explore why bond funds are not a good idea, and why exactly you would want to invest in U.S. Treasury bonds versus corporate debt, which many believe is more optimal because it provides a higher yield.

The Problems with Bond Funds (Mutual Funds, ETFs, UITs, and CEFs)

Many investors are using a multitude of ways to invest in the bond market. From Unit Investment Trusts (UITs) to Closed-End Funds (CEFs) to Exchange-Traded Funds (ETFs), they all offer exposure to different sectors of the bond market, and why not? It is by far the easiest way for an investor to go about investing in the bond market. They can choose from a marketplace of thousands of these types of securities, and mutual funds as well, all promising market beating or matching performance, with easy buy and sell capability.

However, while it may be perceived to be easier, there are many challenges with all of these structures, collectively referred to henceforth as bond funds. While I do not deal extensively with UITs or CEFs, in this piece all of the same issues are applicable and even a few more specific to those structures that make them problematic for individual investors.

Structure

One of the challenges with bond funds is their structure. Up until 2002, only 65% of a bond fund had to actually be the securities in the name. The other 35% could be in cash or other, riskier securities, in an attempt to goose yield and produce better performance. The SEC changed this rule in 2002 to 80% securities in the name, which still leaves 20% of the funds assets that may be in cash, or distressed or risky fare.

As you can see in figure 1, these are the holdings of a very popular bond mutual fund, which holds some positions that investors may not be aware are in their bond fund. In this way a bond fund is a package of securities, when you buy it you buy all of it, the Treasury portion and the junk. In addition, portfolio managers have latitude to make interest rate bets, use derivatives, and use low grade debt to juice returns, adding additional risk exposure to the bond portfolio. In some cases, they are also using leverage to juice returns. In my view, investors should take their risk on the equity side of the portfolio.

Cost

Bond funds carry expense ratios, which are a fee to manage the portfolio of bonds for you. Bond funds also generally carry very high turnover ratios, indicating that the portfolio managers are rapidly turning over the portfolio each year, buying and selling bonds and generating even more costs borne by the investor. Additionally, you may be paying transaction fees to purchase the fund, loads (sales charges) to get into the fund, and 12b-1 fees for the marketing of the fund. All of these fees add up and must be subtracted from your return. Notice the high turnover ratio in figure 1 in the top left corner. Why pay expenses to own bonds that only reduce your overall return on an asset that is supposed to be safe?

FIGURE 1

What About Bond Index Funds?

Many investors think they can avoid all of these challenges by simply choosing bond index funds, but bond index funds carry the same risks as other bond funds; they just offer investors exposure to bonds at a lower cost, with generally less turnover. The fact that the fee is lower does not make it much better; there is still a fee for ongoing management. Additionally, with a bond index, you own everything in that index. If you are tracking the Barclays Aggregate Bond Index, which is the most widely tracked, then you are invested in a sampling of bonds from the index, which include everything from MBS to corporate bonds to a healthy sampling of government agency and Treasury debt. At the end of the day, the portfolio in a bond index fund is far more correlated to the equity market, providing investors little protection against left tail events and market shocks as the table below will demonstrate. Again, it comes back to: why do you own bonds? If the answer is to lower volatility, provide security of principal, and predictable income, then index funds, like their fund peers, do a poor job.

Yield Risk

Because bond fund portfolio managers are turning the portfolio over at such a rapid pace, they buy and sell bonds of varying yields. As a result, there is no predictable yield upon which an investor can depend. The fund's yield will change as the bonds within its portfolio are bought and sold. This provides investors without a predictable rate of income.

With an individual bond, such as a U.S. Treasury security, the payment schedule is set and dependable. This yield risk is particularly a problem for retirees who depend on a fixed rate of income to fund their lifestyles in many cases. The advantages of the highest quality individual bonds become clearer when we look at both the correlation and quality risk factors of a well balanced portfolio model.

Quality & Correlation Risk

A bond investment is considered the safe core portion of an investor's portfolio. Its objective is to reduce volatility and provide a dependable rate of return for a portion of the portfolio. Setting this money aside also allows investors to take risks with the other portion of their portfolio. However, we now hear that investors should shift their bond allocations to riskier and riskier fare to attain additional yield. Many mutual funds are doing just that, increasingly moving into a world of high yield corporate debt, derivatives, and other risky securities that increases the portfolio's risk, and in the case for corporate bonds, have been proven to be positively correlated to the equity market. Some funds in the bond universe are even buying a small allocation to equities!

Let's take three of the largest bond funds and see how they performed during the financial crisis in 2008, a time when you want your bond allocation to do its job, and reduce overall volatility by going up when everything else is going down.

Three Top Mutual Funds Returns 2008 vs. Long Term Zero Coupon U.S. Treasury Securities 2008
Vanguard Total Bond Market Index Fund (VBMFX) 5.05%
Metropolitan West Intermediate Bond Fund (MWIIX) -2.13%
PIMCO Total Return Fund (PTTRX) 4.82%
Vanguard Extended Duration Treasury ETF (EDV) 55.29%

As you can see, all three failed to produce a positive return in a negative environment. Even worse, if we are taking anything resembling equity like risk, we should get paid for that risk. This is the theory behind the equity risk premium. I take more risk with equities but I also achieve a higher return, in theory.

In the second chart below, we look again at various asset class returns during a negative environment. The data continues to support the notion that every portfolio should have some level of exposure to U.S. Treasury bonds, which stand as a negatively correlated asset to many of the other asset classes you may have in your portfolio. Many investors have S&P 500 index, maybe some commodities, EM stocks, Global Developed Market Stocks, but as you can see in a negative environment, all of these asset classes go down together. This demonstrates their high correlation as risk assets. Investors would be wise to diversify the risk exposure rather than diversify the asset classes of their portfolio, because what you might believe is well diversified, is actually not very diversified at all.

Investing in bond funds negates the purpose of bonds in your portfolio. A bond is a part of a portfolio that is absolutely secure. We know when it will pay off and what the yield to maturity is. With a bond fund, you are essentially entering into a perpetual call option on the value of the bonds. Your only way to gain is for bonds to go up, there is no fail safe yield that you can depend on, there is no maturity date. The bond fund merely goes up and down based on the price of the bonds in the portfolio. This enters key risks into the portfolio management process that are unnecessary, not to mention incurring costly management fees for owning bonds in a fund structure. This is especially true at the long end of the curve where bond investors are taking on significant duration risk in a bond mutual fund. Owning individual bonds are the way to go, but not just any bonds, U.S. Treasury Securities, preferably at the long end of the curve.

The Case for the U.S. Treasury Bond

When you buy a corporate bond, you have a yield to maturity, but you are also taking on credit risk from a single issuer. For most investors, they do not have a sufficient portfolio size to diversify their credit issuer risk, and buy a portfolio of bonds from various sectors and companies.

The solution for most investors is to buy a corporate bond fund, but this negates the very reason we own bonds at all - to reduce volatility and create a part of a portfolio that is absolutely secure. This is why only the safety of U.S. Treasury bonds will do. I take on virtually no credit risk, attain a competitive yield to maturity, and have the potential to gain, substantially, from a negative environment.

Those who are familiar with my writing know that I use zero coupon U.S. Treasury bonds at the long end of the curve for tax efficient accounts, and regular Treasuries for taxable accounts, depending on one's tax situation. As I have demonstrated a number of times, not only have these bonds protected an investor's portfolio from left tail risk events and negative equity market environments, but they have also outpaced the S&P 500 index over the past 10, 20, and 30 years.

As you can see from the chart above, U.S. Treasury bonds offer an investor a unique opportunity to own a negatively correlated asset, which serves to reduce portfolio volatility in times of stress.

This is why a portfolio of 50% 30-year zero coupon U.S. Treasury bonds and 50% S&P 500 Index produced a return of 9.14% in 2008. An investor that followed conventional wisdom and owned 50% Vanguard Total Bond Index and 50% Vanguard Total Stock Index (MUTF:VTSMX) would have produced a return of -16%. That's a $160,000 loss on a $1M portfolio. This demonstrates the importance of owning U.S. Treasury bonds versus an index fund, which includes corporate debt and other, possibly riskier securities.

Investors would be wise to follow a strategy that seeks to allocate risk, rather than assuming that owning the total stock and bond markets is sufficient for their investing needs. It is not. As we have seen in the data, an investor who follows this strategy has a portfolio that is far more correlated to equities than they believe. Only the safety and security of U.S. Treasury securities offer investors a port in the stormy seas that markets will inevitably experience.

Conclusion

In conclusion, the question of whether investors should prefer bonds or bond funds is a common one that is asked, and one in which the answers offered traditionally favor the bond fund. This is because most people are focused on owning the total market, or maximizing the yield from the bonds. The reality is that investors seeking to play this game of higher yields would be far better off just owning equities for that portion of their portfolio, and leaving the bond portion to the safety and security of U.S. Treasury securities.

As we have seen, testing real data during the financial crisis of 2008, traditional bond funds would have done a poor job of protecting one's portfolio from the risks of a left tail event. Investors following this traditional approach would have still suffered stiff losses, even in a 50/50 portfolio model. This is because the risk the investor bears is not split 50/50; it skews the risk further towards equities than the investor may realize.

As we saw from the graph above, U.S. Treasury bonds are the only asset that an investor can count on to act positively in a very negative environment. Unfortunately, most investors are being told today to stay away from U.S. Treasuries at "ultra low yields." I have continued to make the case that zero coupon U.S. Treasury bonds at the long end of the curve not only offer investors the protection from negative events that are the very purpose of owning bonds in the first place but also offer them the opportunity to gain from rates falling further.

Economic fundamentals, and an extended equity market that continues to go straight up, give rise to the fear of a market downturn. With a consistently growing debt burden in both governments and households, prospects for GDP growth and equity market returns will likely be subdued. This creates a positive environment for the zero coupon U.S. Treasury bond. Even if my assessments of the economy turn out to be incorrect, holding individual bonds provide a dependable rate of return until maturity. It is for this reason that investors should favor individual U.S. Treasury bonds over bond funds of any stripe.

Disclosure: I am/we are long ZERO COUPON U.S. TREASURY BONDS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.