Bond Ladders and Funds

Yesterday morning I awoke to an interesting article from Mike Piper over at Oblivious Investor. In it, he tackled the issue of whether you should get your bond exposure via mutual funds or through a bond ladder.

For background, a bond ladder is similar to a CD ladder, in that you buy a series of overlapping bonds with staggered maturity dates. That way you get the benefit of (typically) higher long term rates while having access to your money on an ongoing basis.

For their part, many (but not all*) bond mutual funds are a bit like perpetual bond ladders. When one bond expires, another is bought in its place — and so on, for eternity. Thus, if you buy something like the Vanguard Total Bond Market Index Fund, you’re essentially buying into a well diversified, never-ending bond ladder.

*Note: Actively managed bond funds are another beast entirely, as the managers are free to chase yields and might fundamentally change the composition of the portfolio over time.

But what if you want to draw down your bond funds over time? In this case, a bond ladder gives you far more predictability. As it turns out, the value of both bond mutual fund shares and plain old bonds fluctuate over time. When interest rates rise, the value of existing bonds fall — and when rates fall, the value of existing bonds rises.

The important point here is that, as long as you hold an individual bond to maturity (vs. selling it early), you’ll get your original investment back**. In contrast, bond funds never mature — rather, when you sell a share you’re selling a mix of newer and older bonds — so there’s a chance that you’ll have to sell when prices are down if/when you need access to your principal.

**Note: Assuming no defaults.

Other considerations include safety and convenience. I bring these up together because they’re interrelated. If you’re only interested in holding government bonds this is less of an issue, but if you’re looking for exposure to corporate bonds, too, then you’re facing a tough task. If you want to reduce the risks associated with specific companies, you’ll need to buy a large number of individual bonds.

So, in the end, the answer to the question of whether you should hold individual bonds or bond mutual funds is: it depends. As for us, we’re still in the accumulation phase and years away from needing to access our funds. Thus, we’ve been holding a broad-based bond index fund.