#212 - Bonds vs. Bond Funds- Vanguard with Ted Dinucci

Vanguard
Hosts Brad Wright and Chris Boyd are joined by Ted Dinucci, an investment strategist with
Vanguard’s Investment Advisory Research Center, the team tasked with creating thought
leadership for their intermediary advisory partners across a range of investment, wealth
management, and financial planning topics.
They discuss:
-Individual bonds vs bond funds
- How to utilize each for income during retirement
-Which is better during a falling interest rate environment

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Investment Advisory
Research Center

OCTOBER 2022
Individual bonds versus bond funds:
Our thoughts on the advisory
practice and client outcomes

Key takeaways
• Forecasting markets accurately is difficult. A much more reliable prediction to make: What questions
clients will ask during periods of rising interest rates. Inevitably, rising rates environments prompt a
flood of inquiries about whether advisors and their clients are better off purchasing individual bonds
or pooled products, such as mutual funds and exchange-traded funds (ETFs). These questions stem
directly from the “principal at maturity” myth, which argues that bond funds will sell bonds at a loss
when rates rise, while portfolios of individual bonds can be held to maturity and avoid losses.
• Ultimately, bond funds operate the same way as portfolios of individual bonds when cash flows are
being reinvested. However, the former generally offer greater return opportunities, lower transaction
costs, and higher liquidity—as well as time savings for your practice—than comparable portfolios of
individual bonds. Thus, advisors pursuing portfolios of individual bonds should expect to pay greater
direct and indirect costs for maintaining complete control of client bond portfolios. The price tag for
this control is higher for buyers of municipal and corporate bonds than for buyers of U.S. Treasuries.
• 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. Particularly
in the case of municipal and corporate bonds, 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.
• Consider this report as a resource to inform your client discussions—either for proactive conversations
about fixed income portfolio decisions, or to satisfy questions and concerns clients bring to you. For
clients who may be partial to holding individual bonds for emotional reasons, the following analysis
provides you with empirical data points that could guide them to a more beneficial approach. We also
believe the strategies outlined herein can ultimately empower you with more time for higher-value
activities, such as deepening client relationships.

Authors: Ted Dinucci, CFA | Chris Tidmore, CFA, CPA | Chris Pettit, CFA
Acknowledgments: The authors extend our thanks to Elizabeth Muirhead, CFA, and Edward Saracino for their contributions to this report,
and to Donald G. Bennyhoff, CFA, and Scott J. Donaldson, CFA, for their prior research, which greatly informed this paper.

2

Introduction
The market and economic backdrop today appear
highly uncertain, with the highest inflation in 40 years,
a series of large rate hikes from the Federal Reserve,
and Russia’s war in Ukraine, to name a few factors.
Understandably, the confluence of these events has
led to significant market volatility. It’s also led some
investors to question the merits of pooled bond
vehicles and to ask whether they may be better served
by directly owning a portfolio of individual bonds.
In some cases, there can be benefits to owning
individual bonds, for instance, a nominal immunization
strategy where the goal is matching portfolio cash
flows to liabilities. However, for the vast majority of
advisors and the investors they serve, the likely appeal
of individual bonds is largely based on the principal at
maturity myth, and embracing it is likely to diminish
returns, diversification, and return on your time.

This paper offers our perspective on the primary
advantages bond funds have over portfolios of
individual bonds in the three key regards of returns,
diversification, and return on your time (in exchange for
less control over individual securities).1

More important,

for the vast majority, accessing fixed income via low-
cost active or passive funds is likely to provide better

outcomes than the direct ownership of individual
bonds—even with the hurdle of ongoing management
fees. However, we’ll first address the flaws in the
principal at maturity myth, since this misconception is
what generates so much interest in the topic.

FIGURE 1.
Benefits of choosing either a bond fund or individual bond

BOND FUNDS INDIVIDUAL BONDS
INCREASED CONTROL ✓
INCREASED DIVERSIFICATION ✓
INCREASED RETURN OPPORTUNITIES ✓
LOWER TRANSACTION COSTS ✓

1 Vanguard 2017.

3

FIGURE 1.
Benefits of choosing either a bond fund or individual bond

BOND FUNDS INDIVIDUAL BONDS
INCREASED CONTROL ✓
INCREASED DIVERSIFICATION ✓
INCREASED RETURN OPPORTUNITIES ✓
LOWER TRANSACTION COSTS ✓

The principal at maturity myth
Holding an individual bond to maturity offers little to no financial benefit to you or your clients versus a pooled
product when cash flows are reinvested, as often occurs in laddered individual bond strategies.2

Both portfolios
operate in a similar way, but the laddered portfolio is likely to incur greater trading costs and have less diversification.
The way that advisors account for laddered bonds in their client statements—by not marking the bonds to their
current value, in order to avoid recognizing a paper loss—helps to reinforce the behavioral bias and may mitigate
business risk for the advisor.
Ultimately, bond prices are inversely related to changes in interest rates: When interest rates rise, the bond’s price falls,
and vice versa. This is because a bond’s coupon payments are typically fixed at issuance, leaving price as the only variable
that can be adjusted to make the bond’s yield competitive with that of newly issued bonds of similar risk and maturity.
This is illustrated in Figure 2. If 10-year bonds are currently
yielding 4%, the price of a 2% coupon bond—to be
competitive—must decline to a level that results in a 4%
yield-to-maturity. In this example, that price is 83.65% of
the face value (or $836.50 per $1,000 face value). The 2%
bond would provide the same return as the 4% coupon
bond trading at par, but some of the return would come
from the bond’s appreciation from $836.50 to its $1,000
value at maturity, as opposed to the coupon payments.
This price adjustment punctures the common myth that
holding an individual bond to maturity will provide a
financial benefit to your clients. Absent transaction costs,
when interest rates change, prices adjust so that total
returns will be equal from that point forward, regardless
of whether the bond is held to maturity or sold at the
prevailing market price with the proceeds reinvested.

FIGURE 2.
How bond prices adjust to keep yields-to-maturity
the same
A comparison of hypothetical bonds with 10 years to maturity
Coupon (annual
interest payment) 6% 4% 2%
Market price as a
percentage of face value 116.35% 100% 83.65%
Yield to maturity 4% 4% 4%
Source: Vanguard.
This hypothetical illustration does not represent any particular investment
and the rate is not guaranteed.

FIGURE 3.
Total returns closely match starting yields, regardless of whether prices are above (or below) par
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Forward annualized return versus starting yield

Starting yield
Forward annualized return when starting price is above par
Forward annualized return when starting price is below par

Figure 3 demonstrates this point by comparing the forward annualized return for the Bloomberg U.S. Aggregate
Bond Index, adjusted for duration, with its starting yield. Here, it is readily apparent that future returns closely track
starting yields. Moreover, the narrative doesn’t change whether the index is trading above or below par. Therefore,
when evaluating bonds with the same characteristics but with different coupon payments, it is always best to
compare their yields to maturity.3
Notes: Returns represent the annualized return on the Bloomberg U.S. Aggregate Bond Index using monthly data for the period that aligns with the index’s starting
modified adjusted duration, rounded to the nearest month. For instance, if on December 31, 2005, the duration on the index was 5 years, the forward annualized return
would be from January 1, 2006, to December 31, 2010. Yields represent the index’s yield to worst (YTW) at the start of each calculation period. YTW is a measure for the
lowest possible yield that may be earned on a bond absent the issuer defaulting. The last observation in the figure is September 30, 2015, because after that date the
index’s starting duration is longer than the time series.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest
directly in an index.
Sources: Vanguard analysis of Bloomberg data, as of March 2022.
2 Laddering refers to building a portfolio of bonds with a range of maturities.
3 Yield-to-maturity is the percentage rate of return on a bond, assuming that the bond is held to maturity. For bonds that may be called prior to their stated maturity,
yield-to-worst is a preferable measure, as it accounts for the bond’s call feature and represents the lowest possible yield that may be earned assuming no default.

4

As mentioned, this principal at maturity myth typically surfaces only when interest rates rise or are expected to rise.
If rising rates mean there is a financial benefit to holding bonds to maturity, then falling rates should mean there
is a benefit to selling them and reinvesting the proceeds in new bonds. Thus, an active trading strategy would be
preferred over a simple buy-and-hold, laddered bond portfolio to take advantage of the market inefficiency.
Ironically, this environment has been the norm for the past 20-plus years, yet the trading concept has not been
endorsed by the investment community. One doesn’t hear that when interest rates are falling, an open-end mutual
fund or ETF with no set maturity date is the preferred structure. Thus, the appeal of holding a bond to maturity is
likely emotional, as by not selling a bond at a discount to par, your clients are able to avoid the mental roadblock
of “recognizing” a loss. Rather than let this behavioral bias win, advisors can seize this as an opportunity to flex
their coaching muscles and leverage the trust they’ve built with clients to help produce better outcomes. Consider
this analogy: Just because you chose not to sell your house when prices dipped does not mean it’s worth more
than the home of your neighbors, who did sell. The same logic applies to fixed income—whether the bonds are held
individually, in a bond fund, or in a separately managed account (SMA).4
Diversification can mean higher returns for similar levels of risk
In fixed income investing, diversification among issuers, credit qualities, and term structures is a primary
consideration for municipal and corporate bonds. For laddered bond portfolios, issuance calendars do not offer
consistent access to all types of bonds. On the contrary, with bond funds, greater diversification is possible
because of the larger pool of investable assets and the continuous investment in new offerings. This, coupled with
the professional staff needed to conduct risk, trade, and credit analysis allows funds to seek return opportunities
farther out on the credit quality spectrum than is possible for an advisor. In the case of the latter, their clients may
be seriously affected if even one issuer in their (much smaller) portfolio encounters problems.

In the case of corporate bonds (and munis), the dynamic nature of credit risk makes it essential to diversify issuer-
specific risk. The price volatility that results from a change in an issuer’s credit rating is typically asymmetrical:

When a credit downgrade occurs, a bond usually will drop much further in price than it would rise on news of
an upgrade. This means that for holders of individual corporate bonds, the penalty for choosing a bond that is
downgraded is usually greater than the reward for choosing one that gets upgraded. Professional fund managers
who are fully focused on credit analysis may be better suited to spot these trends sooner and avoid the negative
effects of downgrades and defaults.

FIGURE 4.
Incremental pickups in yields available
relative to AA rated corporates Average option-adjusted spread

Average cumulative defaults

0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
1.4%
1.6%

0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%

AA rated Broad investment-grade
Credit quality
0.98%

0.55%

As a result, many individual bond portfolios exhibit
a higher-quality bias relative to bond funds because
of the inability to fully benefit from diversification.
As shown in Figure 4, higher return opportunities,
in terms of incremental yield, are available beyond
AA rated corporates to compensate for the low, but
always possible, risk of default—even when staying
within the corporate investment-grade universe. A
more diversified approach that spans the spectrum
of investment-grade corporates can translate into
a meaningful increase in yield without sacrificing
the primary role of high-quality fixed income in a
portfolio—acting as a ballast to risk assets. It should be
noted that diversification of credit quality can also be
achieved through passive exposure.

Notes: Average option-adjusted spreads (OAS) cover the period of January 1997 to April 2022. AA rated as represented by ICE BofA US Corporate Index Option-Adjusted
Spread; and broad investment-grade as represented by ICE BofA US Corporate Index Option-Adjusted Spread. OAS is a measure of the difference in yield of a bond
and the comparable risk-free rate, adjusted to account for any embedded option. Analysis begins with AA rated corporates, as there are only two AAA rated corporate
issuers. Average cumulative defaults are calculated by FitchRatings and represent the 10-year average cumulative defaults for the period of January 1990 to December
2021. Default rates are calculated on an issuer or security basis as opposed to dollar amounts.
Sources: Federal Reserve Bank of St. Louis, FitchRatings, and Vanguard analysis, as of April 2022.
4 Separately managed accounts are investment portfolios that are directly owned by an investor and managed by a professional investment firm.

5

FIGURE 5.
Growth of hypothetical $1 million
initial investment from January 1997 Ending wealth in (million USD)
$3.2
$3.3
$3.4
$3.5
$3.6
$3.7
$3.8
$3.9
$4.0

AA
corporates

Broad I-G
corporates

$4.1
$4.2

Ending wealth with
AA corporates
Excess wealth
with lower quality

Figure 5 translates the lost return opportunities
in Figure 3 into actual excess wealth created by
expanding the investment opportunity set beyond AA
rated bonds.5 For a long-term investor, being broadly
invested in investment-grade corporates would have
produced an additional $400,000 of nominal wealth,
given a hypothetical, initial $1 million investment in
1997, relative to the same investment in AA rated
corporates. Moreover, through broad diversification, as
an advisor, you would be able to increase your client’s
long-term expected returns for their fixed income
holdings, while significantly reducing single-issuer risk
and still maintain high overall credit quality.

Notes: Figure assumes a hypothetical initial $1 million investment on January 1, 1997, and held until April 30, 2022. AA corporates as represented by ICE BofA 5–10 Year
AA US Corporate Index; and broad I-G corporates as represented by ICE BofA 5–10 Year US Corporate Index.
Sources: Vanguard analysis of Morningstar data, as of April 2022.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest
directly in an index.
Transaction costs are real, but often go overlooked
All bond portfolios incur costs. Though the management cost component often receives the lion’s share of attention
because it is readily apparent and known in advance, it also represents only one part of the equation. Less
scrutinized, but similarly detrimental to long-term financial outcomes are transaction costs (e.g., bid-ask spreads).
Ultimately, bid-ask spreads tend to vary by trade size and bond sector, and the size of the spread is typically
larger for small transactions. Bond mutual funds and ETFs buy and sell large quantities of bonds, and these large
transactions can command higher prices for sales and lower prices for buys. So long as the size of the spreads paid
or received are inversely related to purchase lot size, bond funds have a transaction cost advantage over individual
bond portfolios. The benefits of scale are most significant in the municipal bond market, but still relevant and tell a
similar story to that of corporates.
Figure 6 illustrates this point. It shows that in the
municipal bond market, the spread for a retail trade
(less than $100,000 per bond) on average has been
consistently higher than that for an institutional
trade. Specifically, 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 (bps), 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.6 Additionally, large
firms, such as Vanguard, are able to get the broadest
access to bonds in the primary market, so it’s not only
about the size of the trade and lower costs, but also
what bonds one gets to purchase. This is especially
important as there tends to be a drop-off in liquidity as
time passes from issuance.

FIGURE 6.
Spreads are significantly wider for retail trades
relative to institutional trades (bps)

$10,000 or
less
$10,001-
$25,000
$25,001-
$100,000
$100,001-
$1 million
$1 million+
20.2

56.4
35.5

63.6
81.9

In the end, higher spreads translate into lower returns. Whether creating a taxable or tax-exempt bond portfolio for
a client, the basic decision comes down to this: Does the fund expense ratio detract less from the portfolio’s total
return than (1) the return surrendered by a higher credit-quality bias, if one exists, (2) the default risk, if there is no
quality bias, or (3) the additional transaction costs? It would be rare for the fund expense ratio (particularly in the
case of a lower-cost bond fund) to be larger than the other costs.
Notes: The above figure shows the average effective spread for municipal bond transactions of various sizes from January 2019 to April 2021. Effective spread is a measure
of customer transaction costs and is computed daily for each bond as the difference between the volume-weighted average dealer-to-customer buy and sell price, and is then
averaged across bonds using equal weighting.
Sources: MSRB data and Vanguard analysis.
5 Though an advised client’s fixed income portfolio is unlikely to be comprised of only intermediate-term (5- to 10-year maturity) U.S. corporate bonds.
6 As a simple example, if constructing an initial bond portfolio with an average duration of five years and transaction costs of 50 bps, it would translate to 10 bps per year.

6

Control of the portfolio
One, or perhaps the only, advantage of self-directed
individual bond portfolios and, to some extent, SMAs
over pooled vehicles is the owner’s ability to influence
portfolio decisions. The motivation for maintaining
control generally falls into three camps: strict portfolio
guidelines that place firm restrictions on portfolio
characteristics, such as credit-quality (e.g., all-AA
portfolio) or limits on derivatives usage; matching
portfolio cash-flows with specific liabilities (e.g.,
cash-flow matching); and tax concerns. Given the
inflexibility of the first, and presumably, high-level of
certainty of the second, we’ll focus on the potential
tax considerations, as certain common beliefs may be
overstated and therefore warrant a discussion.
Regarding taxes: Because clients directly own the
bonds in an SMA or a laddered bond portfolio, as their
advisor you can use any net losses from individual
bond positions for tax purposes to partially offset your
client’s earned income or to offset realized capital
gain liabilities from other investments. A mutual
fund or ETF, on the other hand, cannot pass through
realized losses to its shareholders. Instead, the fund
uses realized losses against realized gains, and carries
forward any excess losses to be used against future
gains. Although this may defer the pass-through of
losses, it provides long-term tax efficiency to the
pooled structure. In addition, as the advisor, you have a
further option: You can sell your clients’ fund shares to
realize a loss where applicable.
Regarding individual bond portfolios or SMAs, another
factor to consider is that to take advantage of losses
in these accounts, you will incur transaction costs for

your clients on both the sale of the current bond and
the purchase of the new bond.

Though all the above applies to both taxable and tax-
exempt bonds, in terms of the latter, there is often the

additional consideration of alternative minimum taxes
(AMT). With an individual bond portfolio or SMA, the
portfolio can be tailored to bonds that are exempt
from AMT or specific to issues from your client’s home
state. While this is true, it is important to acknowledge
that there are currently a number of state-specific
vehicles available for your clients—particularly in
states with high tax rates. Also, though it’s sometimes
forgotten, the key point that advisors should be
concerned with is seeking to maximize client after-tax
returns, rather than with minimizing taxes.
Bonds issued outside a client’s home state and bonds
subject to AMT often carry higher yields to maturity.

As a result, your clients may well get higher after-
tax returns from a portfolio including such bonds. In

addition, clients gain from increased diversification—an
important benefit.
With the preceding considerations in mind, it may be
impractical to transition clients from their existing
SMA solutions or portfolios of individual bonds
into a primarily fund-aligned strategy. For advisors
that already utilize an SMA or construct their own
bond sleeves, a bond fund can serve as a strong
complement—by providing some additional liquidity
to the portfolio and a solution for reinvesting periodic
cash flows from their individual bond holdings (or
SMAs) to reduce potential cash drag.

Conclusion
For the reasons described in this paper, the vast majority of advisors who invest for their clients are best served
through low-cost bond funds. Only those advised clients with the resources to achieve scale comparable to that
of a mutual fund should consider putting certain control features ahead of the benefits that a pooled investment
vehicle offers. Funds generally provide better diversification, greater return opportunities, lower transaction costs,
and higher liquidity for your clients. For advisors, the time savings from outsourcing the day-to-day portfolio
management can be reinvested in higher returning opportunities, such as deepening client relationships and
growing your practice.
Although bonds that are held directly can provide certain advantages over bond mutual funds—primarily related to
control over security-specific decisions—such control comes at a cost. To construct an individual bond portfolio, an
advisor must assign a very high value to the control benefits to justify the higher costs and additional risks involved.

6

7

References
Bennyhoff, Donald, Scott Donaldson, Jamese Dunlap, and Daren Roberts, 2017. A topic of current interest: Bonds or
bond funds? Valley Forge, Pa.: The Vanguard Group.
Bennyhoff, Donald G., 2009. Municipal bond funds and individual bonds. Valley Forge, Pa.: The Vanguard Group.
Donaldson, Scott J., 2009. Taxable bond investing: bond funds or individual bonds? Valley Forge, Pa.: The
Vanguard Group.
Li, David, Charlotte L. Needham, and Jake Han, 2022. 2021 Transition and Default Studies. FitchRatings.
Wu, Simon Z., and Nicholas J. Ostroy, 2021. Transaction Costs During the COVID-19 Crisis: A Comparison between
Municipal Securities and Corporate Bond Markets. Washington, D.C., Municipal Securities Rulemaking Board.

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that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a
given level of income.
Bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices
will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
Investments in bonds are subject to interest rate, credit, and inflation risk. Although the income from
municipal bonds held by a fund is exempt from federal tax, you may owe taxes on any capital gains realized
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