No. of Recommendations: 6
We have all viewed the arguments pro and con for investing in bond funds versus individual bonds, e.g. cons for funds include yearly fees, less control over capital gains (if not in IRA or 401k tax protected account), less stable and predictable, and more vulnerable to current market valuations, while the pros for funds include professional management, more diversified, more liquid and easier to reinvest dividends.

While these generalizations can be helpful in deciding whether fund or individual bond investing is better for you, I prefer to look at a cost comparison that also has a measure, albeit not quantitative, of risk included. By that measure, one can more readily see for what one is paying in the terms of the advantages/disadvantages. I do not, however, want to do comparisons of the best total returns (income plus capital gains) that can be realized from investing in a few individual bonds against a fund of many bonds over relatively short time spans. The best and worst returns will be realized by investments in a few individual bonds as any statistical treatment would show, and with an increased risk. These results would be particularly more variable (risky) with investments in a few below investment grade bonds versus a high yield bond fund. Short term trading in relatively small quantities of individual bonds has an associated high cost.

I have some direct knowledge of mutual bond funds, but no investing experience with individual bonds. I have, however, researched both and would like to present a summary of it here for comments and corrections. From my previous polling of this board, where responders were split about 50/50 between fund and individual bond investors, and reading recent past posts, I believe I can receive plenty help here.

Published historical mutual bond fund data are obviously more readily available than that from those doing individual bond investing. As a basis for comparison to individual bond investing, I am using a large mutual fund company with low expenses for which I had a reasonable amount of historical data. I also compare funds returns with those from a Lehman Brothers index that fits most closely as an appropriate bench mark for the fund.

While the Lehman Brothers indexes do not include trading cost and obviously not expense fees, the annual fund costs for these items were approximated in a fund article as being 0.08 and 0.10% for transactions and 0.20 and 0.30% for expense fees. Table 1 shows that the average difference in the returns between the Lehman Brothers bench mark indexes and funds is approximately equal to the expense fees and transaction costs of the funds.

The results in Table 1 also show what the bond fund managers frequently claim: income contributes most of the total returns that accumulate over time. When you factor out the effects of the interest rate cycles not quite being complete for some of the funds shown, the total returns are nearly completely determined by income.

The analogous case with individual bond investing would be holding a bond purchased at par through the interest rate cycle. Under these conditions, where we can assume that the bond rating remained the same, the total return would be determined entirely from income and no capital gains/losses would occur. The difference, which will be examined further below, would be that the individual bond total return would be determined by the dividend rate at the time of purchase, while that of the fund would be determined by purchases and sales of bonds by the fund made during this period and the dividend rates at the time of the transactions.

Purchasing/selling an individual bond at a premium/discount under the conditions described above and selling it at maturity would result in a capital loss/gain. Evidently these types of transactions for the funds listed in Table 1 balance out to give neither a net loss or gain.

In Table 2 the total returns (CAGR) for the LTC bond fund are compared to those for a 20 year corporate bond for several periods and with various hold times. For these periods the individual bond outperformed overall but not in every period. During periods with rising interest rates, the fund has an advantage by "averaging" the rates over the period, while for periods when rates are falling the "averaging" effect works to a disadvantage for the fund.

These comparisons do, however, assume that the individual bonds were not called. I did some research on this issue and found that during the period from 1977 to 1986 the ratio of callable to noncallable bonds issued was 4 to 1. The study did not report individual years but did find that during this period the ratio increased with interest rate levels. My question would then be: how many individual bond investors were actually able to purchase noncallable bonds in or around the 1982 time frame when interest rates for the bonds under discussion were running close to 15%? Another question would be: could a firm paying for debt at these high rates over a 20 year period of time remain viable?

The best case scenario for an individual investing in these bonds would have been to purchase a bond in 1982 for a 46% discount to the par value at which it was issued as a 30 year bond in 1972 and held it 20 years to maturity in 2001 to capture a total return (CAGR) of 18.4% for that 20 year investment. Is anyone at this board aware of anyone being able to do this?

Table 1:
The source is either the mutual fund (XF) or the Lehman Brothers index (LI).
The Type of funds are Corporate with Long Term (LTC), Intermediate Term (ITC), Short Term (STC) and High Yield (HYT); GNMA with its usual meaning; and Treasuries with Long Term (LTT) and Intermediate Term (ITT).
The returns are reported as the past 10 years from Jan 31, 2002 for Income (10Y Inc) and Total Return (10Y TR).
Also included are the Inception date of the fund (In Date) and the Total Return since inception (In TR).
Returns are reported as compounded annual growth rates (CAGR).

Source Type 10Y Inc 10Y TR In Date In TR

XF LTC 7.21% 8.45% 1973 9.01%
LI LTC NA 8.36% ------ 9.15%

XF ITC* 6.74% 6.64% 1993 6.64%
LI ITC NA 6.94% ------ 6.94%

XF STC 6.34% 6.51% 1982 8.27%
LI STC NA 7.07% ------ NA

XF HYC 9.18% 7.74% 1978 9.60%
LI HYC NA 7.28% ------ NA

XF GNMA 7.07% 7.28% 1980 9.40%
LI GNMA NA 7.42% ------ 9.92%

XF LTT 6.67% 8.69% 1986 8.42%
LI LTT NA 9.00% ------ 8.95%

XF ITT 6.29% 7.52% 1991 7.46%
LI ITT NA 7.67% ------ 7.58%

* ITC had existed for 9 years. The 10 year results in table are for that 9 year period.

Table 2:
The total returns (CAGR) are compared between a Long Term Corporate fund from mutual company X and an individual bond that is purchased at par with 20 years to maturity. The returns for the bond are based of the average interest rates of an Aaa and Baa corporate bond. For this analysis the individual bond is assumed to not be callable.
The results are divided into hold periods of 20 years (to maturity), hold 10 years and sell, and hold 5 years and sell.
The one way sell or purchase costs for the individual bond were taken from some recent literature to be 2% of the invested value. Obviously no selling costs were used for a bond taken to maturity.

Period XF LTC Indiv

1972-91 8.0% 7.6%
1982-01 10.9% 14.8%
Ave 9.4% 11.1%

1972-81 5.9% 2.3%
1982-91 13.3% 18.1%
1992-01 8.5% 8.9%
Ave 9.2% 9.6%

1982-86 17.6% 22.1%
1987-91 9.2% 10.3%
1992-96 9.2% 9.2%
1997-01 7.8% 6.8%
Ave 10.9% 12.0%

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