Are Individual Bonds Safer than Bond Funds?

The WSJ was out with a piece discussing outflows from DoubleLine’s Total Return Bond fund this week. One of the reasons for the outflows was cited as the lack of safety in a bond fund:

Among those bailing are individual investors, who helped fuel the fund’s growth but can be quicker than institutions to pull their funds when performance lags. Barney Rothstein, a retired orthodontist in Tucson, Ariz., withdrew $250,000 from the fund over the past 18 months and shifted the money to individual bonds that carry similar yields but can be held to maturity, unlike a bond fund, potentially giving an investor more cushion if the market turns down. “The extra return wasn’t there anymore,” he said.

I touched on this topic in my Biggest Investing Myths series (see here) in a post about the myth that bonds must lose value if rates rise (see here):

A lot of people argue that individual bonds are safer than bond funds, however, this isn’t exactly accurate. Individual bonds expose you to significantly more individual entity risk and as I’ve shown here, a constant maturity bond fund is just as safe as an individual bond when it’s held for the right holding period. Unfortunately, the liquidity of bond funds often lures the investor into treating this long-term instrument as a short-term instrument.  In fact, I’d argue that the ability to see your daily price fluctuations in bond funds significantly increases the behaviorally induced risk of short-termism in bonds.

This is important. A lot of people argue that individual bonds are safer because they can be held to maturity, but a bond fund is nothing more than the summation of all the individual bonds it holds. So, you’re getting greater diversification by reducing the single entity risk in the portfolio, but because you’re diversifying the portfolio you’re blending the maturity date so that the portfolio is constantly being rolled over across time. While it does not have a specific maturity date it does indeed have bonds maturing inside of the portfolio which means that, if you hold the bond fund for the entirety of the average maturity, your portfolio will mature on average and the probability of you seeing negative returns over that period is very low.  And because you’re more diversified there is a high probability that you’re taking less risk than the individual bonds.¹

I would argue that the bigger risk with owning bond funds is that you can see their price daily. While this is also true for individual bonds it’s far less transparent and generally harder to find. In the world of indexing and ETFs we can log-in and check the price of any fund we like. This creates increased behavioral risk in bond funds because the volatility is more noticeable even though the same exact thing is happening in the individual bonds. This is just short-termism at work in the bond market. If you’re going to buy bonds then you should familiarize yourself with their interest rate risk, maturity, etc. and be reasonable about your time horizons. Buying a 30 year T-Bond and then panicking about its 1 day performance because you have a 30 day time horizon is, quite frankly, silly. The instrument, after all, is inherently long-term so your short-termism induces irrational behavioral risk.

The good news is that knowledge is power here. When we take a more operational perspective of the financial system we can see these instruments for what they are instead of looking at them thru the lens of the many biased perspectives that dominate public narratives. And that helps us perform better because it improves our behavior.

¹ – For more on this topic I would recommend Pet Peeve # 10 by Cliff Asness.