The Optometry Money Podcast

Are Individual Bonds Safer Than Bond Funds? What Optometrists Need to Know

• Evon Mendrin • Episode 142

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Are individual bonds better than bond funds? What’s the actual difference between the two—and why does it matter for your investment strategy?

In this episode, Evon Mendrin, CFP®, CSLP®, dives into the key distinctions between individual bonds and bond funds, and what private practice optometrists need to consider when deciding between them. Whether you're aiming for stability, income, or long-term growth in your portfolio, understanding how these investment tools work can guide better financial decisions.

In this episode, you'll learn:

  • What a bond actually is and how it functions
  • The key differences between owning individual bonds and investing in bond funds
  • The pros and cons of each approach
  • Why “safety” in bonds can be misunderstood
  • How market interest rates affect the value of your bonds or bond funds
  • When it may make sense to use one over the other in your financial plan

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The Optometry Money Podcast is dedicated to helping optometrists make better decisions around their money, careers, and practices. The show is hosted by Evon Mendrin, CFP®, CSLP®, owner of Optometry Wealth Advisors, a financial planning firm just for optometrists nationwide.

Evon:

Hey everybody. Welcome back to the Optometry Money Podcast, where we're help anod all over the country make better and better decisions around their money, Their careers, and their practices. I am your host, Evon Mendrin, Certified Financial Planner(TM) practitioner, and owner of Optometry Wealth Advisors, an independent financial planning firm just for optometrists nationwide. And thank you so much for listening. Really appreciate your time and your attention this week. And on today's episode, I'm going to tackle the question I get quite a bit. Are individual bonds safer than bond funds? And there's a lot of misunderstanding about which is safer and which is best for your financial goals. It's often thought that individual bonds are safer. Is that the case? So we're gonna break down some research myths, misconceptions, and some practical thoughts around the differences between individual bonds and bond funds. So to start out, let's just kind of get down to the very basics. What are bonds. Well, bonds are a form of debt. It's a way for corporations, it's a way for countries to raise capital. Just like an Optometry practice, a big publicly traded corporation can raise dollars, they can raise capital by selling shares, by issuing new shares and selling those shares to the public, or they can raise capital by borrowing. Or by issuing bonds and with a government, well, a government can't necessarily sell you ownership of the government, but they can borrow by issuing bonds. And so in theory, if you are buying a bond directly from a government or corporation, you are lending them money, in essence, and every six months or so, which it can vary, but let's just say for the conversations, keep it simple. Every six months or so, those bonds will pay you interest. And then at the end of that bond term, so one month. 10 years, whatever it may be, they'll pay that final bit of interest and you'll get your principal back. And so bonds are a form of debt. It's a form of borrowing. and there are a variety of different types of bonds. As I mentioned, there's government debt, so there's national debt, United States treasuries, Canadian debt, so on and so forth. So national countries can issue debt, can issue bonds. There's municipal bonds for state and local governments. there's also corporate bonds by large corporations like Apple and Disney and Home Depot and so on. There's mortgage backed bonds, which are backed by a collection, a big bundle of mortgages. So there's different types of bonds, there's different types of debt, or we should say, different types of issuers, different entities borrowing from the public. and there's a variety of credit risks and maturities. So credit risk being like the risk that the entity will defaults versus paying back the debt. And there's very highly rated companies and countries you often, you'll see different ratings companies apply ratings, like triple A, double A, triple B, things like that. anything triple B and higher. So triple B and through the A's are going to be considered investment grade of relatively good credit rating. and there's also very poorly rated countries and corporations, And, and those a very wide range of maturity. So you can get one month US government treasuries, that's, which is often considered the risk-free asset. Or you can get five year, 10 year, 20 year, 30 year, I think even a hundred year bonds. So there's a pretty wide range of maturities too. And unlike stocks, bonds don't trade on an exchange. They trade primarily through what's called over the counter, meaning you're, If you're gonna go sell a bond, for example, you're gonna get individual bids to sell each bond. with the exception of some bonds like US Treasuries, which you can buy directly from the US government at the uh, very clunky Treasury Direct website. And from my understanding that some bonds even trade on electronic platforms that are functioning similarly to exchanges. And there are differences in taxation. So for taxable corporate bonds, for example, that interest is taxable income taxed at your ordinary tax rates like 12%, 24%, 22%, and so on. US treasuries the interest from US treasuries are not subject to state income taxes. Municipal bonds, interest from muni bonds are not subject to federal taxes, With the exception of some private activity bonds, which may impact the alternative minimum tax. and so there's differences in taxation, which is important. For example, if you're holding them in a taxable brokerage account. And I. When you compare it to things like stocks, bonds tend to be pretty boring. I mean, a lot of the return is mathematically calculated. Bonds tend to be very math driven. they don't tend to fluctuate nearly as much as the stock market, especially on the upside. So bonds tend to be the boring side of investing, but there is a massive global market for bonds, both corporate bonds and Government bonds. And to talk through a little bit of the anatomy of a bond. What you'll see out there is something called the par value. That's the face value of the bond when it's issued, and the amount that you're gonna get when the bond matures. I. you can of course buy a bond above the par value. The the price of the bond increases above that par value, or you can buy it below. But at the end of the day, if you held that bond to maturity, the par value is the amount you're gonna get. there's also something called a coupon rate. That is the contractual interest rate that you're gonna get as a percentage of that par value. So for example, if you have a 3% coupon rate and a$10,000 par value, then you're going to get$300 of interest a year, 3%. the current yield though, is the interest received compared to the current price, so the annual interest divided by the current price. If the price goes down, well then the current yield is actually higher than the coupon rate. If the price goes up, well, that yield can be lower. And then there's something called a yield to maturity, which you might see out there. And this is sort of the total return of a bond. If you hold it to maturity and it takes into account the interest you're gonna get. the amount of interest payments left and the gain or loss, you're gonna see when you get the par value back, depending on if you, again, bought that bond at a premium above par value or at a discount below par value. So that yields to maturity. If you ever see that online or on statements or anything like that, that is sort of the total return calculation of a bond If you hold it to maturity And so that's kind of the basics of what a bond is. what are bond funds? Well, bond funds are mutual funds or ETFs, exchange traded funds That hold individual bonds inside of it. It's a big basket of individual bonds. Those fund companies pull together all these investors, dollars and they take that money and they invest in a broad basket of bonds. And there's a variety of bond funds, just as much of a variety of bond funds as there is different types of bonds and. They can vary based on their approach. So they can be they can have an index investing approach or a passive rules-based investing approach all the way to very actively managed bond funds. They can invest in US bonds versus international or global bonds. you can have US treasury bonds versus US corporate bonds and short-term bonds, intermediate bonds, long-term bonds, you can have bonds that invest in really high, high credit ratings or investment grade bonds versus the opposite high yield junk bonds and sort of everything in between. So just like there's a variety of different types of bonds and a range of risk versus reward in, in terms of bonds, there's also a pretty wide range of different types of bond funds. one fund can be very different from another. And there are a variety of risks that impacts bonds and also impact your expected return of owning the bond. One important one is default risk or credit risk. That is the risk that the bond issuer is not gonna actually be able to pay back the debt. that's the risk that that issuer defaults on that bond. Which is really important. If you are going to lend an entity some money, you wanna know that they're gonna be able to pay that back. And generally speaking, if the credit rating is worse, or another way to say that, if the Defaults or credit risk is higher, you would expect a higher interest rate, a higher return on that bond over time. another important one is inflation risk, meaning that when you own a bond and that bond matures, there's a risk that inflation is higher than expected by interest rates, and the value of the money you get back is eroded away by inflation. Inflation risk is a really important risk for bonds, especially over really long-term periods. This is really relevant if you are saving and investing towards, long-term financial independence towards retirements, that inflation risk on the bond side of your investments is really important. And then there's an interest rate risk, and that can show up in two different ways. It can show up as you are getting interest payments from the bonds. So cash is coming in and when bonds mature and you get that cash back, because you have to then reinvest that cash into other bonds and there's a chance, there's a risk that you're reinvesting it into lower interest rate bonds, so there's a risk interest rates decline, and you have to reinvest that cash at lower interest rates. Another way interest rate risk shows up is in the fluctuations in prices of bonds. Bond prices can fluctuate up and down, and the thing that can impact the ups and downs of bonds The most, the, the fluctuation in prices the most is probably going to be the changes in interest rates over time. There is an inverse relationship between Interest rates and bond prices. As interest rates go up, you would expect bond prices to come down. As interest rates go down, you would expect bond prices to go up. And why is that? Well, let me give an example. Let's imagine you had a five year bond with a 3% interest rate. And then let's imagine that interest rates increase to 4%. So now other people can buy new five-year bonds earning a 4% interest rate. If you wanted to sell your bond, why would people buy your five-year bond earning 3% when they can buy a brand new five-year bond earning 4%. Well, they probably wouldn't. So in order to incentivize buyers to buy your bond, the market prices of that bond has to decline. And it has to decline enough to where the return the investors is gonna get if they're owning that bond to maturity is the same way either way. So the bond prices are gonna, are going to adjust for that. And to put it in the terms I talked about earlier, the bond prices are gonna adjust to where the yield to maturity is gonna be the same, where that total return, if you hold that to maturity, is gonna be the same with either bond. And that's the same way if interest rates decline, well now bond prices can increase to account for that so that the, the yield that someone's getting if they buy your bond is the same as the lower interest rate. You're not gonna allow someone to buy a bond earning a higher interest rate at the same price. And so, bond prices will react to interest rates and the shorter the maturity of that bond, The lower that price fluctuation is going to be. the longer the maturity of that bond. The more that fluctuation's gonna be, the more sensitive bond prices are gonna be to those changes in interest rates. You might see the term duration. This is a really jargony term. I'm kind of sorry to throw it in here, but if you ever see a term bond duration, that is essentially a measure of the sensitivity, of bond prices or like the prices of a bond mutual fund. To changes in interest rates, the higher the maturity, the higher the duration, the more sensitive that bond or bond fund's gonna be, the more the, the more fluctuation you're gonna see. Whereas shorter maturities, shorter duration, the less sensitive it's gonna be. And so now that we have a sort of foundation, basic understanding of how, of what bonds are, how they work, let's get down to the core question here. Are individual bonds safer and more preferable to bond funds? Well, let's think through this logic a little bit. Let's assume that you are Planning to hold an ongoing portion of your investments in bonds, which most people are. We tend to think of our investments as, for example, 80% stocks and 20% bonds, and that's kind of our ongoing mix for a period of time. So assuming that's the case, let's look at either scenario. Number one, if you are self-managing and buying individual bonds, well, what do you own? You own a bundle or a basket of individual bonds. And because you're holding an ongoing allocation or percentage towards bonds, you're gonna take that cash and continually reinvest that into new bonds. Okay. On the other hand, if you are instead buying a bond fund with the same characteristics of those individual bonds, what do you own? Well, you own a basket of individual bonds. I mean that's, that's what a bond fund is in both cases. In either situation, you are owning a basket of individual bonds when you are self-managing, and when you own individual bonds, you're basically just self-managing a bond fund. So assuming that they have the same characteristics, things like the maturities, the type of bonds they are, the type of default risk, you know, assuming they have the same characteristics, in both cases, they're both going to be subject to the same risks. In both cases, you're gonna have cash to reinvest along the way and maturing bonds to reinvest into new bonds. So in both cases, you run the risk of having to reinvest that cash into lower yielding bonds. In both cases, the prices of bonds will fluctuate based on changes in interest rates and. You see this quite clearly in bond funds as the funds are gonna be priced or marked to market every day, so you actually see the fluctuations and value of those bond funds, especially ETFs, as those trade throughout the day. You may not see this with individual bonds that you own, but this is just a mirage. The prices of your individual bonds will fluctuate in the exact same way. If you were to go out and request a bid for your bonds every single day, you're gonna see that same fluctuation. The value of the price of those bonds are gonna decrease or increase in the same way. So in both cases, you own a basket of individual bonds fluctuating in value. Both are gonna be subject to the same interest rate risks, and in both cases, you're gonna see inflation risk. You're gonna see the risk that inflation erodes the value of those bonds, of that cash as they mature. So either way, We generally don't expect a material difference in individual bonds versus bond funds, assuming again, similar types of bonds with similar characteristics. In both situations, you're gonna have a bunch of individual bonds that are maturing over time with cash and interest coming in, and you're gonna have to continually reinvest that cash. It's really the same either way. I think what a lot of investors are thinking about when they think about the safety of individual bonds are the. What's what we would commonly refer to as the hold to maturity myth. There is a common belief that individual bonds are safer because you can hold them, hold them to maturity, and you get your principle back, like regardless of the fluctuations of these bond funds, hey, if you just hold your bond to maturity, you're gonna get your principle back. But as we talked about, your individual bonds will fluctuate in the same way. And what we see mathematically, and I'll include some research, a report from Vanguard talking through this as well, that for ongoing portfolio allocations to bonds, meaning you're continuing to hold an ongoing percentage of your portfolio towards bonds, We should not expect an economic difference between the two. We should not expect an economic difference in the outcomes between holding bonds to maturity and a bond fund manager deciding to buy and sell bonds as they fluctuate. Because in either case, mathematically. Because both approaches rely on the same underlying cash flows that the bonds are creating. The expected total return of a well diversified ladder or mix of individual bonds, and the low cost bond fund with similar credit quality and duration tends to converge in the same direction. The outcomes are likely to look similar once reinvestment and expenses are considered. With the obvious disclaimer that actual results will vary with costs and taxes and market conditions and so forth. Assuming again, these are bonds with similar characteristics. Let's kind of talk to an example why this is the case. Because, for example, if interest rates go up, what we know is that both individual bonds and bond funds lose value in the short term. So we know that the price of bond funds go down, and we also know that the price of your bond went down as well. But even if you sold that bond at a loss and bought a new one, your outcome mathematically would be the same before transaction costs than if you just held that bond to maturity, why? Because you're immediately getting that higher interest rate through the life of the bond. That's why again, bond prices adjust so that the yields to maturity, the total return with either option would be the same through maturity. And so, this safety that people feel with individual bonds, this idea that you can hold it to maturity, there's safety in that. Whereas bond funds, you see them fluctuate in try in price. What we see is that that's more psychological than reality. It, it's a, it's a myth. It's a myth. It's a bit of a mirage. And trading individual bonds comes with additional costs and disadvantages. So what are those costs and disadvantages? Number one, trading costs. Firstly, your trading costs are likely to be higher if you're buying individual bonds on your own rather than an institutional manager. Unless you're only buying US treasuries, which you can buy directly from the US government, it's going to be more costly for you buying at lower volume to buy individual bonds rather than an institutional fund manager buying it at much larger scale. Fund managers are able to minimize these trading costs with the scale that they're working with. As an example, a 2020 study, which I'll link to in the show notes by S&P Dow Jones, looked at transaction costs for investment grade municipal bonds for muni bonds. In it, they find that bond purchases of$10,000 or less cost an average of 0.9 of a percent. Purchases between$10,000 and 25,000 cost an average of 0.71 of a percent, and purchases between 25,000 and a hundred thousand. Cost 0.61 of 1%. Those extra costs, which are implicit, you don't actually see them as you would an expense ratio on a fund. You just experienced lower returns. Those, those extra costs matter a whole lot with bonds is there's a much lower Return expectation and you'd see with the stock market over long periods of time. Yes, bond funds have management fees to consider, especially if you are considering like a really traditional, actively managed bond fund. But compare this to something like a total bond market index fund or a similar passive style fund that may come with costs under a 10th of a percent. To maybe a quarter of a percent or so. So those trading costs can definitely add up. Number two. The second point is diversification. It takes a pretty substantial amount of money to have an appropriately diversified basket of bonds unless you're only buying US treasuries. Where there is in theory no default risk, you're only deciding at that point between how long you want the maturities to go. If you're buying corporate or other bonds appropriately, diversifying a way, the default risks unique to that one issuer are extremely important. You're not likely going to have the capital needed to appropriately diversify across a range of different corporations and governments, different issuers, different credit qualities, and different maturities. If you're going to invest in bonds globally, you're probably not gonna be able to do it well and hedge the currency risk Of those foreign bonds appropriately. So from a diversification standpoint, it's much more difficult to get appropriate diversification when you as an individual are buying individual bonds. The third thing to consider is cash drag. If you're collecting coupon payments, interest from individual bonds. Every six months or so, you may not be able to immediately reinvest the cash into other bonds. You may have to wait over time to have enough cash to bought a new lot of bonds, and so it's likely to cause some cash drag on your investments. You may have to wait until bonds actually mature in order to do that well. Whereas a bond fund can efficiently handle reinvesting cash from both the large collection and diversity of bonds that it manages, as well as the inflows of cash into the bond itself. And so they're much more efficiently able to reinvest that cash into new bonds as well as to maintain sort of that risk, that risk reward characteristic of the bonds that they want to hold. And there's also liquidity risk with individual bonds. Some issues, some bond issues don't trade very often, so if you have to sell it in order to create cash, you might not be able to find a buyer or you might have to accept a lower price if you need to sell pretty quickly. You can expect bond funds to maintain their liquidity as the owner of the fund rather than the individual bonds inside. The benefit, however, of owning individual bonds instead of a bond fund is really control. You get to control when and whether to sell the bond and buy another if you want to, versus holding to maturity. You can also control the types of bonds that you're buying, assuming of course you have the knowledge and skill to trade and manage the bonds, and so in reality. You are just preferring to actively manage your own bond fund, which is fine. Let's, let's acknowledge that. But in terms of risks, What research and bond math suggests is that we would not expect there to be material differences in risk between the two. Assuming, again, similar characteristics, but you need to put a pretty high value on that control with the other costs and some of the disadvantages that we talked about above. I think a lot of the misconception comes from, the, firstly, the misunderstanding that individual bonds change in price. Just like bond funds. I think a lot of time we see the fluctuation in bond funds and we don't sort, and we don't associate that to our own individual bonds, so we feel like there's some artificial safety there that's not really there. And I also think there's very often a comparison of apples to oranges. Meaning we might look at individual bonds like short term US treasuries and compare that to a bond fund that owns longer term corporate bonds or a high yield bond fund, or a total market bond fund. And these are often just comparisons between two very different piles of bonds with different characteristics of risk and return, and we would expect them to behave differently. Now, this is all assuming, of course, you're owning an ongoing percentage or amount of your investments in bonds. It's a little different if you are owning, if you are planning for a very specific expense at a very specific time in the future, so this is actually very different because you can buy a bond with a certain interest rate that matures at the exact time you might need it. Let's say for example, have a very specific expense coming up in five years. Let's just say it's a down payment on a commercial property. And you know it's gonna be an exact amount after inflation in exactly five years from now. Okay? So what you can do is you can buy an individual bond and especially a treasury bond or a TIPS a Treasury Inflation Protected security. And so you can buy that individual bond. With a set amount of interest at a certain dollar amount and that will mature in five years at exactly the time you need it. So that's different. That type of direct, like liability matching can be a place where an individual bond makes sense, that being said, you're still gonna be subject to that risk of inflation causing that future expense to be higher than you expect. But in terms of long-term allocations to bonds, like we talked about earlier, What research tells us and what bond math suggests to us is that we should not expect a material difference in risk b etween owning a bundle of individual bonds versus a bond fund that owns bonds with similar characteristics. I think a lot of this just comes down to knowing what you want out of the bonds, what you're owning the bonds for, knowing what type of bonds you wanna own, and matching the type of bond funds appropriately towards that. For example, when I invest for clients. I'm not looking for return necessarily out of the bonds themselves. What I'm looking for in bonds is an addition of stability to the investments where it makes sense for that family. So I'm looking for bond funds that are owning bonds that are intermediate to shorter maturities, so the maturities aren't necessarily on the longer side, and I'm looking for investment grade bonds or higher. So on the lower default risk, I'm looking again, not necessarily for returns, but the addition of stability. where I want to get the returns are on the stock side, I want my stock mix to be the re long-term return driver of the investment mix, and so I can mix and match to get the appropriate mix of long-term investment returns versus stability in the short term that makes sense for that family. But you have to decide that for yourself. What are you investing towards? What is the timeframe? What type of bonds make sense? And then you can go and find the individual bonds if you want to manage it yourself. Or the bond funds that match that investment goal. Of course, keeping in mind the approach of that bond fund and the fees involved. And so hopefully this is helpful to give you sort of a, a, a quick overview of what bonds are, how they work, and what I think is a common misconception about owning individual bonds versus bond funds. So if you have any questions, please reach out to me at podcast@optometrywealth.com if you want to talk and talk through your own investment mix and your own investment goals. please reach out. I'll throw a link in the show notes to our website where you can schedule a no commitment introductory call. We can talk about what's on your mind financially, including the investments, and I can share how I help optometrists all over the country navigate those same questions and more. And if you're not ready to reach out, have that conversation, I'll also include a link in the show notes to our weekly Eyes on the Money newsletter where I write all about investing student loans, managing practice finances and more. And with that, appreciate your time, we'll catch you on the next episode. In the meantime, take care.

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Evon Mendrin CFP®, CSLP®

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