June 27, 2025 • 28 mins
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Are individual bonds better than bond funds? What’s the actual difference between the two—and why does it matter for your investment strategy?
In this episode, Evon Mendrin, CFP®, CSLP®, dives into the key distinctions between individual bonds and bond funds, and what private practice optometrists need to consider when deciding between them. Whether you're aiming for stability, income, or long-term growth in your portfolio, understanding how these investment tools work can guide better financial decisions.
In this episode, you'll learn:
- What a bond actually is and how it functions
- The key differences between owning individual bonds and investing in bond funds
- The pros and cons of each approach
- Why “safety” in bonds can be misunderstood
- How market interest rates affect the value of your bonds or bond funds
- When it may make sense to use one over the other in your financial plan
Resources mentioned:
- Vanguard: Individual Bonds vs. Bond Funds
- Vanguard: Taxable Bond Investing - Bond Fund vs. Individual Bonds
- US Treasury Direct
- S&P Dow Jones: The Hidden Costs of Retail Purchases in Investment Grade Municipal Bonds
- A Wealth of Common Sense Blog: Owning Individual Bonds vs. A Bond Fund
Related Episodes:
- Podcast Ep 58: Investing Fundamentals – Understanding Stocks, Bonds, Mutual Funds, and ETFs
- Ep 134: The Case for Index Funds – Why Optometrists Should Embrace Passive Investing
Stay Connected:
- Click here to Subscribe to the Eyes On The Money Newsletter for weekly financial insights tailored specifically to optometrists.
- Have Questions? CLICK HERE to schedule a short introductory call
The Optometry Money Podcast is dedicated to helping optometrists make better decisions around their money, careers, and practices. The show is hosted by Evon Mendrin, CFP®, CSLP®, owner of Optometry Wealth Advisors, a financial planning firm just for optometrists nationwide.
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Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Evon (00:04):
Hey everybody.
Welcome back to the OptometryMoney Podcast, where we're help
anod all over the country makebetter and better decisions
around their money, Theircareers, and their practices.
I am your host, Evon Mendrin,Certified Financial Planner(TM)
practitioner, and owner ofOptometry Wealth Advisors, an
independent financial planningfirm just for optometrists
(00:24):
nationwide.
And thank you so much forlistening.
Really appreciate your time andyour attention this week.
And on today's episode, I'mgoing to tackle the question I
get quite a bit.
Are individual bonds safer thanbond funds?
And there's a lot ofmisunderstanding about which is
safer and which is best for yourfinancial goals.
(00:46):
It's often thought thatindividual bonds are safer.
Is that the case?
So we're gonna break down someresearch myths, misconceptions,
and some practical thoughtsaround the differences between
individual bonds and bond funds.
So to start out, let's just kindof get down to the very basics.
What are bonds.
Well, bonds are a form of debt.
(01:07):
It's a way for corporations,it's a way for countries to
raise capital.
Just like an Optometry practice,a big publicly traded
corporation can raise dollars,they can raise capital by
selling shares, by issuing newshares and selling those shares
to the public, or they can raisecapital by borrowing.
(01:27):
Or by issuing bonds and with agovernment, well, a government
can't necessarily sell youownership of the government, but
they can borrow by issuingbonds.
And so in theory, if you arebuying a bond directly from a
government or corporation, youare lending them money, in
essence, and every six months orso, which it can vary, but let's
(01:49):
just say for the conversations,keep it simple.
Every six months or so, thosebonds will pay you interest.
And then at the end of that bondterm, so one month.
10 years, whatever it may be,they'll pay that final bit of
interest and you'll get yourprincipal back.
And so bonds are a form of debt.
It's a form of borrowing.
and there are a variety ofdifferent types of bonds.
(02:11):
As I mentioned, there'sgovernment debt, so there's
national debt, United Statestreasuries, Canadian debt, so on
and so forth.
So national countries can issuedebt, can issue bonds.
There's municipal bonds forstate and local governments.
there's also corporate bonds bylarge corporations like Apple
and Disney and Home Depot and soon.
(02:31):
There's mortgage backed bonds,which are backed by a
collection, a big bundle ofmortgages.
So there's different types ofbonds, there's different types
of debt, or we should say,different types of issuers,
different entities borrowingfrom the public.
and there's a variety of creditrisks and maturities.
So credit risk being like therisk that the entity will
(02:52):
defaults versus paying back thedebt.
And there's very highly ratedcompanies and countries you
often, you'll see differentratings companies apply ratings,
like triple A, double A, tripleB, things like that.
anything triple B and higher.
So triple B and through the A'sare going to be considered
investment grade of relativelygood credit rating.
(03:15):
and there's also very poorlyrated countries and
corporations, And, and those avery wide range of maturity.
So you can get one month USgovernment treasuries, that's,
which is often considered therisk-free asset.
Or you can get five year, 10year, 20 year, 30 year, I think
even a hundred year bonds.
So there's a pretty wide rangeof maturities too.
(03:37):
And unlike stocks, bonds don'ttrade on an exchange.
They trade primarily throughwhat's called over the counter,
meaning you're, If you're gonnago sell a bond, for example,
you're gonna get individual bidsto sell each bond.
with the exception of some bondslike US Treasuries, which you
can buy directly from the USgovernment at the uh, very
clunky Treasury Direct website.
(03:58):
And from my understanding thatsome bonds even trade on
electronic platforms that arefunctioning similarly to
exchanges.
And there are differences intaxation.
So for taxable corporate bonds,for example, that interest is
taxable income taxed at yourordinary tax rates like 12%,
24%, 22%, and so on.
US treasuries the interest fromUS treasuries are not subject to
(04:21):
state income taxes.
Municipal bonds, interest frommuni bonds are not subject to
federal taxes, With theexception of some private
activity bonds, which may impactthe alternative minimum tax.
and so there's differences intaxation, which is important.
For example, if you're holdingthem in a taxable brokerage
account.
And I.
When you compare it to thingslike stocks, bonds tend to be
(04:42):
pretty boring.
I mean, a lot of the return ismathematically calculated.
Bonds tend to be very mathdriven.
they don't tend to fluctuatenearly as much as the stock
market, especially on theupside.
So bonds tend to be the boringside of investing, but there is
a massive global market forbonds, both corporate bonds and
(05:04):
Government bonds.
And to talk through a little bitof the anatomy of a bond.
What you'll see out there issomething called the par value.
That's the face value of thebond when it's issued, and the
amount that you're gonna getwhen the bond matures.
I.
you can of course buy a bondabove the par value.
The the price of the bondincreases above that par value,
(05:26):
or you can buy it below.
But at the end of the day, ifyou held that bond to maturity,
the par value is the amountyou're gonna get.
there's also something called acoupon rate.
That is the contractual interestrate that you're gonna get as a
percentage of that par value.
So for example, if you have a 3%coupon rate and a$10,000 par
(05:47):
value, then you're going to get$300 of interest a year, 3%.
the current yield though, is theinterest received compared to
the current price, so the annualinterest divided by the current
price.
If the price goes down, wellthen the current yield is
actually higher than the couponrate.
If the price goes up, well, thatyield can be lower.
(06:09):
And then there's somethingcalled a yield to maturity,
which you might see out there.
And this is sort of the totalreturn of a bond.
If you hold it to maturity andit takes into account the
interest you're gonna get.
the amount of interest paymentsleft and the gain or loss,
you're gonna see when you getthe par value back, depending on
if you, again, bought that bondat a premium above par value or
(06:32):
at a discount below par value.
So that yields to maturity.
If you ever see that online oron statements or anything like
that, that is sort of the totalreturn calculation of a bond If
you hold it to maturity And sothat's kind of the basics of
what a bond is.
what are bond funds?
Well, bond funds are mutualfunds or ETFs, exchange traded
funds That hold individual bondsinside of it.
(06:54):
It's a big basket of individualbonds.
Those fund companies pulltogether all these investors,
dollars and they take that moneyand they invest in a broad
basket of bonds.
And there's a variety of bondfunds, just as much of a variety
of bond funds as there isdifferent types of bonds and.
They can vary based on theirapproach.
So they can be they can have anindex investing approach or a
(07:17):
passive rules-based investingapproach all the way to very
actively managed bond funds.
They can invest in US bondsversus international or global
bonds.
you can have US treasury bondsversus US corporate bonds and
short-term bonds, intermediatebonds, long-term bonds, you can
have bonds that invest in reallyhigh, high credit ratings or
(07:39):
investment grade bonds versusthe opposite high yield junk
bonds and sort of everything inbetween.
So just like there's a varietyof different types of bonds and
a range of risk versus rewardin, in terms of bonds, there's
also a pretty wide range ofdifferent types of bond funds.
one fund can be very differentfrom another.
And there are a variety of risksthat impacts bonds and also
(08:03):
impact your expected return ofowning the bond.
One important one is defaultrisk or credit risk.
That is the risk that the bondissuer is not gonna actually be
able to pay back the debt.
that's the risk that that issuerdefaults on that bond.
Which is really important.
If you are going to lend anentity some money, you wanna
know that they're gonna be ableto pay that back.
(08:24):
And generally speaking, if thecredit rating is worse, or
another way to say that, if theDefaults or credit risk is
higher, you would expect ahigher interest rate, a higher
return on that bond over time.
another important one isinflation risk, meaning that
when you own a bond and thatbond matures, there's a risk
that inflation is higher thanexpected by interest rates, and
(08:48):
the value of the money you getback is eroded away by
inflation.
Inflation risk is a reallyimportant risk for bonds,
especially over really long-termperiods.
This is really relevant if youare saving and investing
towards, long-term financialindependence towards
retirements, that inflation riskon the bond side of your
investments is really important.
And then there's an interestrate risk, and that can show up
(09:09):
in two different ways.
It can show up as you aregetting interest payments from
the bonds.
So cash is coming in and whenbonds mature and you get that
cash back, because you have tothen reinvest that cash into
other bonds and there's achance, there's a risk that
you're reinvesting it into lowerinterest rate bonds, so there's
a risk interest rates decline,and you have to reinvest that
(09:32):
cash at lower interest rates.
Another way interest rate riskshows up is in the fluctuations
in prices of bonds.
Bond prices can fluctuate up anddown, and the thing that can
impact the ups and downs ofbonds The most, the, the
fluctuation in prices the mostis probably going to be the
changes in interest rates overtime.
(09:53):
There is an inverse relationshipbetween Interest rates and bond
prices.
As interest rates go up, youwould expect bond prices to come
down.
As interest rates go down, youwould expect bond prices to go
up.
And why is that?
Well, let me give an example.
Let's imagine you had a fiveyear bond with a 3% interest
(10:13):
rate.
And then let's imagine thatinterest rates increase to 4%.
So now other people can buy newfive-year bonds earning a 4%
interest rate.
If you wanted to sell your bond,why would people buy your
five-year bond earning 3% whenthey can buy a brand new
five-year bond earning 4%.
Well, they probably wouldn't.
(10:33):
So in order to incentivizebuyers to buy your bond, the
market prices of that bond hasto decline.
And it has to decline enough towhere the return the investors
is gonna get if they're owningthat bond to maturity is the
same way either way.
So the bond prices are gonna,are going to adjust for that.
(10:55):
And to put it in the terms Italked about earlier, the bond
prices are gonna adjust to wherethe yield to maturity is gonna
be the same, where that totalreturn, if you hold that to
maturity, is gonna be the samewith either bond.
And that's the same way ifinterest rates decline, well now
bond prices can increase toaccount for that so that the,
(11:15):
the yield that someone's gettingif they buy your bond is the
same as the lower interest rate.
You're not gonna allow someoneto buy a bond earning a higher
interest rate at the same price.
And so, bond prices will reactto interest rates and the
shorter the maturity of thatbond, The lower that price
fluctuation is going to be.
the longer the maturity of thatbond.
(11:35):
The more that fluctuation'sgonna be, the more sensitive
bond prices are gonna be tothose changes in interest rates.
You might see the term duration.
This is a really jargony term.
I'm kind of sorry to throw it inhere, but if you ever see a term
bond duration, that isessentially a measure of the
sensitivity, of bond prices orlike the prices of a bond mutual
(11:58):
fund.
To changes in interest rates,the higher the maturity, the
higher the duration, the moresensitive that bond or bond
fund's gonna be, the more the,the more fluctuation you're
gonna see.
Whereas shorter maturities,shorter duration, the less
sensitive it's gonna be.
And so now that we have a sortof foundation, basic
understanding of how, of whatbonds are, how they work, let's
(12:21):
get down to the core questionhere.
Are individual bonds safer andmore preferable to bond funds?
Well, let's think through thislogic a little bit.
Let's assume that you arePlanning to hold an ongoing
portion of your investments inbonds, which most people are.
We tend to think of ourinvestments as, for example, 80%
stocks and 20% bonds, and that'skind of our ongoing mix for a
(12:45):
period of time.
So assuming that's the case,let's look at either scenario.
Number one, if you areself-managing and buying
individual bonds, well, what doyou own?
You own a bundle or a basket ofindividual bonds.
And because you're holding anongoing allocation or percentage
towards bonds, you're gonna takethat cash and continually
(13:06):
reinvest that into new bonds.
Okay.
On the other hand, if you areinstead buying a bond fund with
the same characteristics ofthose individual bonds, what do
you own?
Well, you own a basket ofindividual bonds.
I mean that's, that's what abond fund is in both cases.
In either situation, you areowning a basket of individual
(13:30):
bonds when you areself-managing, and when you own
individual bonds, you'rebasically just self-managing a
bond fund.
So assuming that they have thesame characteristics, things
like the maturities, the type ofbonds they are, the type of
default risk, you know, assumingthey have the same
characteristics, in both cases,they're both going to be subject
(13:52):
to the same risks.
In both cases, you're gonna havecash to reinvest along the way
and maturing bonds to reinvestinto new bonds.
So in both cases, you run therisk of having to reinvest that
cash into lower yielding bonds.
In both cases, the prices ofbonds will fluctuate based on
changes in interest rates and.
(14:13):
You see this quite clearly inbond funds as the funds are
gonna be priced or marked tomarket every day, so you
actually see the fluctuationsand value of those bond funds,
especially ETFs, as those tradethroughout the day.
You may not see this withindividual bonds that you own,
but this is just a mirage.
(14:34):
The prices of your individualbonds will fluctuate in the
exact same way.
If you were to go out andrequest a bid for your bonds
every single day, you're gonnasee that same fluctuation.
The value of the price of thosebonds are gonna decrease or
increase in the same way.
So in both cases, you own abasket of individual bonds
fluctuating in value.
(14:55):
Both are gonna be subject to thesame interest rate risks, and in
both cases, you're gonna seeinflation risk.
You're gonna see the risk thatinflation erodes the value of
those bonds, of that cash asthey mature.
So either way, We generallydon't expect a material
difference in individual bondsversus bond funds, assuming
(15:15):
again, similar types of bondswith similar characteristics.
In both situations, you're gonnahave a bunch of individual bonds
that are maturing over time withcash and interest coming in, and
you're gonna have to continuallyreinvest that cash.
It's really the same either way.
I think what a lot of investorsare thinking about when they
think about the safety ofindividual bonds are the.
(15:37):
What's what we would commonlyrefer to as the hold to maturity
myth.
There is a common belief thatindividual bonds are safer
because you can hold them, holdthem to maturity, and you get
your principle back, likeregardless of the fluctuations
of these bond funds, hey, if youjust hold your bond to maturity,
you're gonna get your principleback.
(15:57):
But as we talked about, yourindividual bonds will fluctuate
in the same way.
And what we see mathematically,and I'll include some research,
a report from Vanguard talkingthrough this as well, that for
ongoing portfolio allocations tobonds, meaning you're continuing
to hold an ongoing percentage ofyour portfolio towards bonds, We
(16:19):
should not expect an economicdifference between the two.
We should not expect an economicdifference in the outcomes
between holding bonds tomaturity and a bond fund manager
deciding to buy and sell bondsas they fluctuate.
Because in either case,mathematically.
Because both approaches rely onthe same underlying cash flows
(16:40):
that the bonds are creating.
The expected total return of awell diversified ladder or mix
of individual bonds, and the lowcost bond fund with similar
credit quality and durationtends to converge in the same
direction.
The outcomes are likely to looksimilar once reinvestment and
(17:00):
expenses are considered.
With the obvious disclaimer thatactual results will vary with
costs and taxes and marketconditions and so forth.
Assuming again, these are bondswith similar characteristics.
Let's kind of talk to an examplewhy this is the case.
Because, for example, ifinterest rates go up, what we
know is that both individualbonds and bond funds lose value
(17:22):
in the short term.
So we know that the price ofbond funds go down, and we also
know that the price of your bondwent down as well.
But even if you sold that bondat a loss and bought a new one,
your outcome mathematicallywould be the same before
transaction costs than if youjust held that bond to maturity,
(17:44):
why?
Because you're immediatelygetting that higher interest
rate through the life of thebond.
That's why again, bond pricesadjust so that the yields to
maturity, the total return witheither option would be the same
through maturity.
And so, this safety that peoplefeel with individual bonds, this
(18:05):
idea that you can hold it tomaturity, there's safety in
that.
Whereas bond funds, you see themfluctuate in try in price.
What we see is that that's morepsychological than reality.
It, it's a, it's a myth.
It's a myth.
It's a bit of a mirage.
And trading individual bondscomes with additional costs and
disadvantages.
So what are those costs anddisadvantages?
(18:27):
Number one, trading costs.
Firstly, your trading costs arelikely to be higher if you're
buying individual bonds on yourown rather than an institutional
manager.
Unless you're only buying UStreasuries, which you can buy
directly from the US government,it's going to be more costly for
you buying at lower volume tobuy individual bonds rather than
(18:49):
an institutional fund managerbuying it at much larger scale.
Fund managers are able tominimize these trading costs
with the scale that they'reworking with.
As an example, a 2020 study,which I'll link to in the show
notes by S&P Dow Jones, lookedat transaction costs for
investment grade municipal bondsfor muni bonds.
(19:09):
In it, they find that bondpurchases of$10,000 or less cost
an average of 0.9 of a percent.
Purchases between$10,000 and25,000 cost an average of 0.71
of a percent, and purchasesbetween 25,000 and a hundred
thousand.
Cost 0.61 of 1%.
(19:33):
Those extra costs, which areimplicit, you don't actually see
them as you would an expenseratio on a fund.
You just experienced lowerreturns.
Those, those extra costs mattera whole lot with bonds is
there's a much lower Returnexpectation and you'd see with
the stock market over longperiods of time.
Yes, bond funds have managementfees to consider, especially if
(19:56):
you are considering like areally traditional, actively
managed bond fund.
But compare this to somethinglike a total bond market index
fund or a similar passive stylefund that may come with costs
under a 10th of a percent.
To maybe a quarter of a percentor so.
So those trading costs candefinitely add up.
(20:18):
Number two.
The second point isdiversification.
It takes a pretty substantialamount of money to have an
appropriately diversified basketof bonds unless you're only
buying US treasuries.
Where there is in theory nodefault risk, you're only
deciding at that point betweenhow long you want the maturities
to go.
If you're buying corporate orother bonds appropriately,
(20:41):
diversifying a way, the defaultrisks unique to that one issuer
are extremely important.
You're not likely going to havethe capital needed to
appropriately diversify across arange of different corporations
and governments, differentissuers, different credit
qualities, and differentmaturities.
If you're going to invest inbonds globally, you're probably
(21:01):
not gonna be able to do it welland hedge the currency risk Of
those foreign bondsappropriately.
So from a diversificationstandpoint, it's much more
difficult to get appropriatediversification when you as an
individual are buying individualbonds.
The third thing to consider iscash drag.
If you're collecting couponpayments, interest from
(21:22):
individual bonds.
Every six months or so, you maynot be able to immediately
reinvest the cash into otherbonds.
You may have to wait over timeto have enough cash to bought a
new lot of bonds, and so it'slikely to cause some cash drag
on your investments.
You may have to wait until bondsactually mature in order to do
that well.
(21:43):
Whereas a bond fund canefficiently handle reinvesting
cash from both the largecollection and diversity of
bonds that it manages, as wellas the inflows of cash into the
bond itself.
And so they're much moreefficiently able to reinvest
that cash into new bonds as wellas to maintain sort of that
risk, that risk rewardcharacteristic of the bonds that
(22:05):
they want to hold.
And there's also liquidity riskwith individual bonds.
Some issues, some bond issuesdon't trade very often, so if
you have to sell it in order tocreate cash, you might not be
able to find a buyer or youmight have to accept a lower
price if you need to sell prettyquickly.
You can expect bond funds tomaintain their liquidity as the
(22:28):
owner of the fund rather thanthe individual bonds inside.
The benefit, however, of owningindividual bonds instead of a
bond fund is really control.
You get to control when andwhether to sell the bond and buy
another if you want to, versusholding to maturity.
You can also control the typesof bonds that you're buying,
(22:49):
assuming of course you have theknowledge and skill to trade and
manage the bonds, and so inreality.
You are just preferring toactively manage your own bond
fund, which is fine.
Let's, let's acknowledge that.
But in terms of risks, Whatresearch and bond math suggests
is that we would not expectthere to be material differences
(23:09):
in risk between the two.
Assuming, again, similarcharacteristics, but you need to
put a pretty high value on thatcontrol with the other costs and
some of the disadvantages thatwe talked about above.
I think a lot of themisconception comes from, the,
firstly, the misunderstandingthat individual bonds change in
price.
Just like bond funds.
(23:29):
I think a lot of time we see thefluctuation in bond funds and we
don't sort, and we don'tassociate that to our own
individual bonds, so we feellike there's some artificial
safety there that's not reallythere.
And I also think there's veryoften a comparison of apples to
oranges.
Meaning we might look atindividual bonds like short term
US treasuries and compare thatto a bond fund that owns longer
(23:53):
term corporate bonds or a highyield bond fund, or a total
market bond fund.
And these are often justcomparisons between two very
different piles of bonds withdifferent characteristics of
risk and return, and we wouldexpect them to behave
differently.
Now, this is all assuming, ofcourse, you're owning an ongoing
(24:14):
percentage or amount of yourinvestments in bonds.
It's a little different if youare owning, if you are planning
for a very specific expense at avery specific time in the
future, so this is actually verydifferent because you can buy a
bond with a certain interestrate that matures at the exact
(24:36):
time you might need it.
Let's say for example, have avery specific expense coming up
in five years.
Let's just say it's a downpayment on a commercial
property.
And you know it's gonna be anexact amount after inflation in
exactly five years from now.
Okay?
So what you can do is you canbuy an individual bond and
especially a treasury bond or aTIPS a Treasury Inflation
(24:58):
Protected security.
And so you can buy thatindividual bond.
With a set amount of interest ata certain dollar amount and that
will mature in five years atexactly the time you need it.
So that's different.
That type of direct, likeliability matching can be a
place where an individual bondmakes sense, that being said,
(25:20):
you're still gonna be subject tothat risk of inflation causing
that future expense to be higherthan you expect.
But in terms of long-termallocations to bonds, like we
talked about earlier, Whatresearch tells us and what bond
math suggests to us is that weshould not expect a material
difference in risk b etweenowning a bundle of individual
bonds versus a bond fund thatowns bonds with similar
(25:42):
characteristics.
I think a lot of this just comesdown to knowing what you want
out of the bonds, what you'reowning the bonds for, knowing
what type of bonds you wannaown, and matching the type of
bond funds appropriately towardsthat.
For example, when I invest forclients.
I'm not looking for returnnecessarily out of the bonds
themselves.
What I'm looking for in bonds isan addition of stability to the
(26:06):
investments where it makes sensefor that family.
So I'm looking for bond fundsthat are owning bonds that are
intermediate to shortermaturities, so the maturities
aren't necessarily on the longerside, and I'm looking for
investment grade bonds orhigher.
So on the lower default risk,I'm looking again, not
necessarily for returns, but theaddition of stability.
(26:28):
where I want to get the returnsare on the stock side, I want my
stock mix to be the re long-termreturn driver of the investment
mix, and so I can mix and matchto get the appropriate mix of
long-term investment returnsversus stability in the short
term that makes sense for thatfamily.
But you have to decide that foryourself.
What are you investing towards?
(26:49):
What is the timeframe?
What type of bonds make sense?
And then you can go and find theindividual bonds if you want to
manage it yourself.
Or the bond funds that matchthat investment goal.
Of course, keeping in mind theapproach of that bond fund and
the fees involved.
And so hopefully this is helpfulto give you sort of a, a, a
quick overview of what bondsare, how they work, and what I
(27:12):
think is a common misconceptionabout owning individual bonds
versus bond funds.
So if you have any questions,please reach out to me at
podcast@optometrywealth.com ifyou want to talk and talk
through your own investment mixand your own investment goals.
please reach out.
I'll throw a link in the shownotes to our website where you
can schedule a no commitmentintroductory call.
(27:32):
We can talk about what's on yourmind financially, including the
investments, and I can share howI help optometrists all over the
country navigate those samequestions and more.
And if you're not ready to reachout, have that conversation,
I'll also include a link in theshow notes to our weekly Eyes on
the Money newsletter where Iwrite all about investing
student loans, managing practicefinances and more.
(27:54):
And with that, appreciate yourtime, we'll catch you on the
next episode.
In the meantime, take care.
Hey everybody.
Welcome back to the OptometryMoney Podcast, where we're help
anod all over the country makebetter and better decisions
around their money, Theircareers, and their practices.
I am your host, Evon Mendrin,Certified Financial Planner(TM)
practitioner, and owner ofOptometry Wealth Advisors, an
independent financial planningfirm just for optometrists
(00:24):
nationwide.
And thank you so much forlistening.
Really appreciate your time andyour attention this week.
And on today's episode, I'mgoing to tackle the question I
get quite a bit.
Are individual bonds safer thanbond funds?
And there's a lot ofmisunderstanding about which is
safer and which is best for yourfinancial goals.
(00:46):
It's often thought thatindividual bonds are safer.
Is that the case?
So we're gonna break down someresearch myths, misconceptions,
and some practical thoughtsaround the differences between
individual bonds and bond funds.
So to start out, let's just kindof get down to the very basics.
What are bonds.
Well, bonds are a form of debt.
(01:07):
It's a way for corporations,it's a way for countries to
raise capital.
Just like an Optometry practice,a big publicly traded
corporation can raise dollars,they can raise capital by
selling shares, by issuing newshares and selling those shares
to the public, or they can raisecapital by borrowing.
(01:27):
Or by issuing bonds and with agovernment, well, a government
can't necessarily sell youownership of the government, but
they can borrow by issuingbonds.
And so in theory, if you arebuying a bond directly from a
government or corporation, youare lending them money, in
essence, and every six months orso, which it can vary, but let's
(01:49):
just say for the conversations,keep it simple.
Every six months or so, thosebonds will pay you interest.
And then at the end of that bondterm, so one month.
10 years, whatever it may be,they'll pay that final bit of
interest and you'll get yourprincipal back.
And so bonds are a form of debt.
It's a form of borrowing.
and there are a variety ofdifferent types of bonds.
(02:11):
As I mentioned, there'sgovernment debt, so there's
national debt, United Statestreasuries, Canadian debt, so on
and so forth.
So national countries can issuedebt, can issue bonds.
There's municipal bonds forstate and local governments.
there's also corporate bonds bylarge corporations like Apple
and Disney and Home Depot and soon.
(02:31):
There's mortgage backed bonds,which are backed by a
collection, a big bundle ofmortgages.
So there's different types ofbonds, there's different types
of debt, or we should say,different types of issuers,
different entities borrowingfrom the public.
and there's a variety of creditrisks and maturities.
So credit risk being like therisk that the entity will
(02:52):
defaults versus paying back thedebt.
And there's very highly ratedcompanies and countries you
often, you'll see differentratings companies apply ratings,
like triple A, double A, tripleB, things like that.
anything triple B and higher.
So triple B and through the A'sare going to be considered
investment grade of relativelygood credit rating.
(03:15):
and there's also very poorlyrated countries and
corporations, And, and those avery wide range of maturity.
So you can get one month USgovernment treasuries, that's,
which is often considered therisk-free asset.
Or you can get five year, 10year, 20 year, 30 year, I think
even a hundred year bonds.
So there's a pretty wide rangeof maturities too.
(03:37):
And unlike stocks, bonds don'ttrade on an exchange.
They trade primarily throughwhat's called over the counter,
meaning you're, If you're gonnago sell a bond, for example,
you're gonna get individual bidsto sell each bond.
with the exception of some bondslike US Treasuries, which you
can buy directly from the USgovernment at the uh, very
clunky Treasury Direct website.
(03:58):
And from my understanding thatsome bonds even trade on
electronic platforms that arefunctioning similarly to
exchanges.
And there are differences intaxation.
So for taxable corporate bonds,for example, that interest is
taxable income taxed at yourordinary tax rates like 12%,
24%, 22%, and so on.
US treasuries the interest fromUS treasuries are not subject to
(04:21):
state income taxes.
Municipal bonds, interest frommuni bonds are not subject to
federal taxes, With theexception of some private
activity bonds, which may impactthe alternative minimum tax.
and so there's differences intaxation, which is important.
For example, if you're holdingthem in a taxable brokerage
account.
And I.
When you compare it to thingslike stocks, bonds tend to be
(04:42):
pretty boring.
I mean, a lot of the return ismathematically calculated.
Bonds tend to be very mathdriven.
they don't tend to fluctuatenearly as much as the stock
market, especially on theupside.
So bonds tend to be the boringside of investing, but there is
a massive global market forbonds, both corporate bonds and
(05:04):
Government bonds.
And to talk through a little bitof the anatomy of a bond.
What you'll see out there issomething called the par value.
That's the face value of thebond when it's issued, and the
amount that you're gonna getwhen the bond matures.
I.
you can of course buy a bondabove the par value.
The the price of the bondincreases above that par value,
(05:26):
or you can buy it below.
But at the end of the day, ifyou held that bond to maturity,
the par value is the amountyou're gonna get.
there's also something called acoupon rate.
That is the contractual interestrate that you're gonna get as a
percentage of that par value.
So for example, if you have a 3%coupon rate and a$10,000 par
(05:47):
value, then you're going to get$300 of interest a year, 3%.
the current yield though, is theinterest received compared to
the current price, so the annualinterest divided by the current
price.
If the price goes down, wellthen the current yield is
actually higher than the couponrate.
If the price goes up, well, thatyield can be lower.
(06:09):
And then there's somethingcalled a yield to maturity,
which you might see out there.
And this is sort of the totalreturn of a bond.
If you hold it to maturity andit takes into account the
interest you're gonna get.
the amount of interest paymentsleft and the gain or loss,
you're gonna see when you getthe par value back, depending on
if you, again, bought that bondat a premium above par value or
(06:32):
at a discount below par value.
So that yields to maturity.
If you ever see that online oron statements or anything like
that, that is sort of the totalreturn calculation of a bond If
you hold it to maturity And sothat's kind of the basics of
what a bond is.
what are bond funds?
Well, bond funds are mutualfunds or ETFs, exchange traded
funds That hold individual bondsinside of it.
(06:54):
It's a big basket of individualbonds.
Those fund companies pulltogether all these investors,
dollars and they take that moneyand they invest in a broad
basket of bonds.
And there's a variety of bondfunds, just as much of a variety
of bond funds as there isdifferent types of bonds and.
They can vary based on theirapproach.
So they can be they can have anindex investing approach or a
(07:17):
passive rules-based investingapproach all the way to very
actively managed bond funds.
They can invest in US bondsversus international or global
bonds.
you can have US treasury bondsversus US corporate bonds and
short-term bonds, intermediatebonds, long-term bonds, you can
have bonds that invest in reallyhigh, high credit ratings or
(07:39):
investment grade bonds versusthe opposite high yield junk
bonds and sort of everything inbetween.
So just like there's a varietyof different types of bonds and
a range of risk versus rewardin, in terms of bonds, there's
also a pretty wide range ofdifferent types of bond funds.
one fund can be very differentfrom another.
And there are a variety of risksthat impacts bonds and also
(08:03):
impact your expected return ofowning the bond.
One important one is defaultrisk or credit risk.
That is the risk that the bondissuer is not gonna actually be
able to pay back the debt.
that's the risk that that issuerdefaults on that bond.
Which is really important.
If you are going to lend anentity some money, you wanna
know that they're gonna be ableto pay that back.
(08:24):
And generally speaking, if thecredit rating is worse, or
another way to say that, if theDefaults or credit risk is
higher, you would expect ahigher interest rate, a higher
return on that bond over time.
another important one isinflation risk, meaning that
when you own a bond and thatbond matures, there's a risk
that inflation is higher thanexpected by interest rates, and
(08:48):
the value of the money you getback is eroded away by
inflation.
Inflation risk is a reallyimportant risk for bonds,
especially over really long-termperiods.
This is really relevant if youare saving and investing
towards, long-term financialindependence towards
retirements, that inflation riskon the bond side of your
investments is really important.
And then there's an interestrate risk, and that can show up
(09:09):
in two different ways.
It can show up as you aregetting interest payments from
the bonds.
So cash is coming in and whenbonds mature and you get that
cash back, because you have tothen reinvest that cash into
other bonds and there's achance, there's a risk that
you're reinvesting it into lowerinterest rate bonds, so there's
a risk interest rates decline,and you have to reinvest that
(09:32):
cash at lower interest rates.
Another way interest rate riskshows up is in the fluctuations
in prices of bonds.
Bond prices can fluctuate up anddown, and the thing that can
impact the ups and downs ofbonds The most, the, the
fluctuation in prices the mostis probably going to be the
changes in interest rates overtime.
(09:53):
There is an inverse relationshipbetween Interest rates and bond
prices.
As interest rates go up, youwould expect bond prices to come
down.
As interest rates go down, youwould expect bond prices to go
up.
And why is that?
Well, let me give an example.
Let's imagine you had a fiveyear bond with a 3% interest
(10:13):
rate.
And then let's imagine thatinterest rates increase to 4%.
So now other people can buy newfive-year bonds earning a 4%
interest rate.
If you wanted to sell your bond,why would people buy your
five-year bond earning 3% whenthey can buy a brand new
five-year bond earning 4%.
Well, they probably wouldn't.
(10:33):
So in order to incentivizebuyers to buy your bond, the
market prices of that bond hasto decline.
And it has to decline enough towhere the return the investors
is gonna get if they're owningthat bond to maturity is the
same way either way.
So the bond prices are gonna,are going to adjust for that.
(10:55):
And to put it in the terms Italked about earlier, the bond
prices are gonna adjust to wherethe yield to maturity is gonna
be the same, where that totalreturn, if you hold that to
maturity, is gonna be the samewith either bond.
And that's the same way ifinterest rates decline, well now
bond prices can increase toaccount for that so that the,
(11:15):
the yield that someone's gettingif they buy your bond is the
same as the lower interest rate.
You're not gonna allow someoneto buy a bond earning a higher
interest rate at the same price.
And so, bond prices will reactto interest rates and the
shorter the maturity of thatbond, The lower that price
fluctuation is going to be.
the longer the maturity of thatbond.
(11:35):
The more that fluctuation'sgonna be, the more sensitive
bond prices are gonna be tothose changes in interest rates.
You might see the term duration.
This is a really jargony term.
I'm kind of sorry to throw it inhere, but if you ever see a term
bond duration, that isessentially a measure of the
sensitivity, of bond prices orlike the prices of a bond mutual
(11:58):
fund.
To changes in interest rates,the higher the maturity, the
higher the duration, the moresensitive that bond or bond
fund's gonna be, the more the,the more fluctuation you're
gonna see.
Whereas shorter maturities,shorter duration, the less
sensitive it's gonna be.
And so now that we have a sortof foundation, basic
understanding of how, of whatbonds are, how they work, let's
(12:21):
get down to the core questionhere.
Are individual bonds safer andmore preferable to bond funds?
Well, let's think through thislogic a little bit.
Let's assume that you arePlanning to hold an ongoing
portion of your investments inbonds, which most people are.
We tend to think of ourinvestments as, for example, 80%
stocks and 20% bonds, and that'skind of our ongoing mix for a
(12:45):
period of time.
So assuming that's the case,let's look at either scenario.
Number one, if you areself-managing and buying
individual bonds, well, what doyou own?
You own a bundle or a basket ofindividual bonds.
And because you're holding anongoing allocation or percentage
towards bonds, you're gonna takethat cash and continually
(13:06):
reinvest that into new bonds.
Okay.
On the other hand, if you areinstead buying a bond fund with
the same characteristics ofthose individual bonds, what do
you own?
Well, you own a basket ofindividual bonds.
I mean that's, that's what abond fund is in both cases.
In either situation, you areowning a basket of individual
(13:30):
bonds when you areself-managing, and when you own
individual bonds, you'rebasically just self-managing a
bond fund.
So assuming that they have thesame characteristics, things
like the maturities, the type ofbonds they are, the type of
default risk, you know, assumingthey have the same
characteristics, in both cases,they're both going to be subject
(13:52):
to the same risks.
In both cases, you're gonna havecash to reinvest along the way
and maturing bonds to reinvestinto new bonds.
So in both cases, you run therisk of having to reinvest that
cash into lower yielding bonds.
In both cases, the prices ofbonds will fluctuate based on
changes in interest rates and.
(14:13):
You see this quite clearly inbond funds as the funds are
gonna be priced or marked tomarket every day, so you
actually see the fluctuationsand value of those bond funds,
especially ETFs, as those tradethroughout the day.
You may not see this withindividual bonds that you own,
but this is just a mirage.
(14:34):
The prices of your individualbonds will fluctuate in the
exact same way.
If you were to go out andrequest a bid for your bonds
every single day, you're gonnasee that same fluctuation.
The value of the price of thosebonds are gonna decrease or
increase in the same way.
So in both cases, you own abasket of individual bonds
fluctuating in value.
(14:55):
Both are gonna be subject to thesame interest rate risks, and in
both cases, you're gonna seeinflation risk.
You're gonna see the risk thatinflation erodes the value of
those bonds, of that cash asthey mature.
So either way, We generallydon't expect a material
difference in individual bondsversus bond funds, assuming
(15:15):
again, similar types of bondswith similar characteristics.
In both situations, you're gonnahave a bunch of individual bonds
that are maturing over time withcash and interest coming in, and
you're gonna have to continuallyreinvest that cash.
It's really the same either way.
I think what a lot of investorsare thinking about when they
think about the safety ofindividual bonds are the.
(15:37):
What's what we would commonlyrefer to as the hold to maturity
myth.
There is a common belief thatindividual bonds are safer
because you can hold them, holdthem to maturity, and you get
your principle back, likeregardless of the fluctuations
of these bond funds, hey, if youjust hold your bond to maturity,
you're gonna get your principleback.
(15:57):
But as we talked about, yourindividual bonds will fluctuate
in the same way.
And what we see mathematically,and I'll include some research,
a report from Vanguard talkingthrough this as well, that for
ongoing portfolio allocations tobonds, meaning you're continuing
to hold an ongoing percentage ofyour portfolio towards bonds, We
(16:19):
should not expect an economicdifference between the two.
We should not expect an economicdifference in the outcomes
between holding bonds tomaturity and a bond fund manager
deciding to buy and sell bondsas they fluctuate.
Because in either case,mathematically.
Because both approaches rely onthe same underlying cash flows
(16:40):
that the bonds are creating.
The expected total return of awell diversified ladder or mix
of individual bonds, and the lowcost bond fund with similar
credit quality and durationtends to converge in the same
direction.
The outcomes are likely to looksimilar once reinvestment and
(17:00):
expenses are considered.
With the obvious disclaimer thatactual results will vary with
costs and taxes and marketconditions and so forth.
Assuming again, these are bondswith similar characteristics.
Let's kind of talk to an examplewhy this is the case.
Because, for example, ifinterest rates go up, what we
know is that both individualbonds and bond funds lose value
(17:22):
in the short term.
So we know that the price ofbond funds go down, and we also
know that the price of your bondwent down as well.
But even if you sold that bondat a loss and bought a new one,
your outcome mathematicallywould be the same before
transaction costs than if youjust held that bond to maturity,
(17:44):
why?
Because you're immediatelygetting that higher interest
rate through the life of thebond.
That's why again, bond pricesadjust so that the yields to
maturity, the total return witheither option would be the same
through maturity.
And so, this safety that peoplefeel with individual bonds, this
(18:05):
idea that you can hold it tomaturity, there's safety in
that.
Whereas bond funds, you see themfluctuate in try in price.
What we see is that that's morepsychological than reality.
It, it's a, it's a myth.
It's a myth.
It's a bit of a mirage.
And trading individual bondscomes with additional costs and
disadvantages.
So what are those costs anddisadvantages?
(18:27):
Number one, trading costs.
Firstly, your trading costs arelikely to be higher if you're
buying individual bonds on yourown rather than an institutional
manager.
Unless you're only buying UStreasuries, which you can buy
directly from the US government,it's going to be more costly for
you buying at lower volume tobuy individual bonds rather than
(18:49):
an institutional fund managerbuying it at much larger scale.
Fund managers are able tominimize these trading costs
with the scale that they'reworking with.
As an example, a 2020 study,which I'll link to in the show
notes by S&P Dow Jones, lookedat transaction costs for
investment grade municipal bondsfor muni bonds.
(19:09):
In it, they find that bondpurchases of$10,000 or less cost
an average of 0.9 of a percent.
Purchases between$10,000 and25,000 cost an average of 0.71
of a percent, and purchasesbetween 25,000 and a hundred
thousand.
Cost 0.61 of 1%.
(19:33):
Those extra costs, which areimplicit, you don't actually see
them as you would an expenseratio on a fund.
You just experienced lowerreturns.
Those, those extra costs mattera whole lot with bonds is
there's a much lower Returnexpectation and you'd see with
the stock market over longperiods of time.
Yes, bond funds have managementfees to consider, especially if
(19:56):
you are considering like areally traditional, actively
managed bond fund.
But compare this to somethinglike a total bond market index
fund or a similar passive stylefund that may come with costs
under a 10th of a percent.
To maybe a quarter of a percentor so.
So those trading costs candefinitely add up.
(20:18):
Number two.
The second point isdiversification.
It takes a pretty substantialamount of money to have an
appropriately diversified basketof bonds unless you're only
buying US treasuries.
Where there is in theory nodefault risk, you're only
deciding at that point betweenhow long you want the maturities
to go.
If you're buying corporate orother bonds appropriately,
(20:41):
diversifying a way, the defaultrisks unique to that one issuer
are extremely important.
You're not likely going to havethe capital needed to
appropriately diversify across arange of different corporations
and governments, differentissuers, different credit
qualities, and differentmaturities.
If you're going to invest inbonds globally, you're probably
(21:01):
not gonna be able to do it welland hedge the currency risk Of
those foreign bondsappropriately.
So from a diversificationstandpoint, it's much more
difficult to get appropriatediversification when you as an
individual are buying individualbonds.
The third thing to consider iscash drag.
If you're collecting couponpayments, interest from
(21:22):
individual bonds.
Every six months or so, you maynot be able to immediately
reinvest the cash into otherbonds.
You may have to wait over timeto have enough cash to bought a
new lot of bonds, and so it'slikely to cause some cash drag
on your investments.
You may have to wait until bondsactually mature in order to do
that well.
(21:43):
Whereas a bond fund canefficiently handle reinvesting
cash from both the largecollection and diversity of
bonds that it manages, as wellas the inflows of cash into the
bond itself.
And so they're much moreefficiently able to reinvest
that cash into new bonds as wellas to maintain sort of that
risk, that risk rewardcharacteristic of the bonds that
(22:05):
they want to hold.
And there's also liquidity riskwith individual bonds.
Some issues, some bond issuesdon't trade very often, so if
you have to sell it in order tocreate cash, you might not be
able to find a buyer or youmight have to accept a lower
price if you need to sell prettyquickly.
You can expect bond funds tomaintain their liquidity as the
(22:28):
owner of the fund rather thanthe individual bonds inside.
The benefit, however, of owningindividual bonds instead of a
bond fund is really control.
You get to control when andwhether to sell the bond and buy
another if you want to, versusholding to maturity.
You can also control the typesof bonds that you're buying,
(22:49):
assuming of course you have theknowledge and skill to trade and
manage the bonds, and so inreality.
You are just preferring toactively manage your own bond
fund, which is fine.
Let's, let's acknowledge that.
But in terms of risks, Whatresearch and bond math suggests
is that we would not expectthere to be material differences
(23:09):
in risk between the two.
Assuming, again, similarcharacteristics, but you need to
put a pretty high value on thatcontrol with the other costs and
some of the disadvantages thatwe talked about above.
I think a lot of themisconception comes from, the,
firstly, the misunderstandingthat individual bonds change in
price.
Just like bond funds.
(23:29):
I think a lot of time we see thefluctuation in bond funds and we
don't sort, and we don'tassociate that to our own
individual bonds, so we feellike there's some artificial
safety there that's not reallythere.
And I also think there's veryoften a comparison of apples to
oranges.
Meaning we might look atindividual bonds like short term
US treasuries and compare thatto a bond fund that owns longer
(23:53):
term corporate bonds or a highyield bond fund, or a total
market bond fund.
And these are often justcomparisons between two very
different piles of bonds withdifferent characteristics of
risk and return, and we wouldexpect them to behave
differently.
Now, this is all assuming, ofcourse, you're owning an ongoing
(24:14):
percentage or amount of yourinvestments in bonds.
It's a little different if youare owning, if you are planning
for a very specific expense at avery specific time in the
future, so this is actually verydifferent because you can buy a
bond with a certain interestrate that matures at the exact
(24:36):
time you might need it.
Let's say for example, have avery specific expense coming up
in five years.
Let's just say it's a downpayment on a commercial
property.
And you know it's gonna be anexact amount after inflation in
exactly five years from now.
Okay?
So what you can do is you canbuy an individual bond and
especially a treasury bond or aTIPS a Treasury Inflation
(24:58):
Protected security.
And so you can buy thatindividual bond.
With a set amount of interest ata certain dollar amount and that
will mature in five years atexactly the time you need it.
So that's different.
That type of direct, likeliability matching can be a
place where an individual bondmakes sense, that being said,
(25:20):
you're still gonna be subject tothat risk of inflation causing
that future expense to be higherthan you expect.
But in terms of long-termallocations to bonds, like we
talked about earlier, Whatresearch tells us and what bond
math suggests to us is that weshould not expect a material
difference in risk b etweenowning a bundle of individual
bonds versus a bond fund thatowns bonds with similar
(25:42):
characteristics.
I think a lot of this just comesdown to knowing what you want
out of the bonds, what you'reowning the bonds for, knowing
what type of bonds you wannaown, and matching the type of
bond funds appropriately towardsthat.
For example, when I invest forclients.
I'm not looking for returnnecessarily out of the bonds
themselves.
What I'm looking for in bonds isan addition of stability to the
(26:06):
investments where it makes sensefor that family.
So I'm looking for bond fundsthat are owning bonds that are
intermediate to shortermaturities, so the maturities
aren't necessarily on the longerside, and I'm looking for
investment grade bonds orhigher.
So on the lower default risk,I'm looking again, not
necessarily for returns, but theaddition of stability.
(26:28):
where I want to get the returnsare on the stock side, I want my
stock mix to be the re long-termreturn driver of the investment
mix, and so I can mix and matchto get the appropriate mix of
long-term investment returnsversus stability in the short
term that makes sense for thatfamily.
But you have to decide that foryourself.
What are you investing towards?
(26:49):
What is the timeframe?
What type of bonds make sense?
And then you can go and find theindividual bonds if you want to
manage it yourself.
Or the bond funds that matchthat investment goal.
Of course, keeping in mind theapproach of that bond fund and
the fees involved.
And so hopefully this is helpfulto give you sort of a, a, a
quick overview of what bondsare, how they work, and what I
(27:12):
think is a common misconceptionabout owning individual bonds
versus bond funds.
So if you have any questions,please reach out to me at
podcast@optometrywealth.com ifyou want to talk and talk
through your own investment mixand your own investment goals.
please reach out.
I'll throw a link in the shownotes to our website where you
can schedule a no commitmentintroductory call.
(27:32):
We can talk about what's on yourmind financially, including the
investments, and I can share howI help optometrists all over the
country navigate those samequestions and more.
And if you're not ready to reachout, have that conversation,
I'll also include a link in theshow notes to our weekly Eyes on
the Money newsletter where Iwrite all about investing
student loans, managing practicefinances and more.
(27:54):
And with that, appreciate yourtime, we'll catch you on the
next episode.
In the meantime, take care.
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