4 Reasons to Pick Bond Funds Over Individual Bonds: Vanguard

What You Need to Know

Holding a bond to maturity offers little benefit over bond funds, Vanguard said.
A bond fund operates similarly to a bond ladder but with lower costs, according to the asset manager.
However, owning individual bonds has tax advantages.

Buying individual bonds may offer advisors and clients greater control than investing in bond funds, but low-cost funds have four major advantages — greater return opportunities, lower transaction expenses, better diversification and higher liquidity, according to a recent report from Vanguard.

It’s a myth that holding an individual bond to maturity will help investors avoid losses when interest rates rise, providing a benefit over bond funds, the mutual fund and ETF giant said. Holding a bond to maturity offers little to no financial benefit to advisors or clients, Vanguard said.

A laddered strategy, in which a client buys individual bonds with staggered maturity dates, often involves reinvesting cash flows, as bond funds also do, the firm noted.

“Both portfolios operate in a similar way, but the laddered portfolio is likely to incur greater trading costs and have less diversification,” the report said.

Bond funds consistently reinvest at the current rate, which tends to smooth out the lumpiness, Chris Tidmore, senior manager of Vanguard’s Investment Advisory Research Center, told ThinkAdvisor on Friday.

“Given the higher risks and costs associated with portfolios of individual bonds, and the time they take to manage, most advisors are better served by low-cost mutual funds and ETFs,” the report said.

“Particularly in the case of municipal and corporate bonds (versus U.S. Treasurys) it is likely that only clients with enough resources to build a portfolio of comparable scale to a mutual fund or ETF can afford to pay the costs for these control advantages,” it said.

Lower Transaction Costs

Larger trade sizes are much less expensive in the corporate and muni space, which generally translates into lower costs for bond funds, Tidmore explained.

Vanguard’s report included a chart showing that in the municipal bond market, the spread for a retail trade under $100,000 per bond was consistently higher on average than spreads on institutional trades.

Between January 2019 and April 2021, the effective spread for transactions with a par value between $25,001 and $100,000 averaged 56.4 basis points, while transactions with a par value of over $1 million averaged 20.2 bps.

“This differential translates to lower total return for clients who are not able to transact at scale,” the report said, suggesting that large institutions also have access to more bonds. ”In the end, higher spreads translate into lower returns.”