In my previous post, I looked at the uneasiness many investors have about bonds when interest rates are poised to go up. Some readers have argued that this discomfort can be alleviated by buying individual bonds rather than index funds or ETFs. Let’s look at whether their arguments hold up.

Individual bonds do offer benefits: you know precisely how much interest you’ll be paid, and how much you’ll receive when the bond matures. The payouts from bond funds, by contrast, aren’t known in advance, and funds never mature. This can make planning difficult for those who rely on their bond portfolio for current income, or those who need a specified amount of money on a certain date in the future. No quibbles with that.

The other main argument in favour of individual bonds is much less convincing. It goes something like this: “If I invest $10,000 in a bond fund, its value will go down when interest rates rise. But if I buy an individual bond, I don’t have to worry about interest rate movements, because as long as I hold the bond to maturity, my principal is guaranteed.”

Behavioural economists love this kind of logic. While it’s true that holding a bond (or a GIC) to maturity allows you to collect the full principal, you’re fooling yourself if you think you’ve avoided a loss. Consider a bond that has two years left to maturity and pays 4% interest when the current rate for comparable bonds is 5%. Over the next two years you’re locked into an investment earning 4% interest, when you could be earning 5% with no additional risk. You may not have lost your capital, but you have forfeited $200 in interest. This opportunity cost may not feel the same as losing capital, but in the long run it affects your investment returns the same as any other kind of loss.

There are several other advantages of using index funds or ETFs rather than individual bonds:

Diversification. Canadian government bonds are highly unlikely to default, but corporate bonds certainly can. Just ask the investors who put their retirement savings in bonds from General Motors. You can dramatically reduce default risk by investing in an ETF like iShares’ Canadian Corporate Bond Index Fund (XCB), which holds 350 different issues. A wide selection of bonds with various maturities can also reduce interest rate risk.

Low minimum investment. Many bond issues require $10,000 or more, so building a customized bond ladder is out of the reach of many small investors. By contrast, Claymore’s 1–5 Year Laddered Government Bond ETF (CLF) includes a ready-made ladder of 25 bonds, and small investors can buy in for any amount. Bond index funds also have very low minimums ($100 to $1,000) and you can take advantage of dollar-cost averaging by adding money each month, something you can’t do with individual bonds.

Liquidity. You can redeem all or part of a bond fund at any time if you need the cash, typically with no fee (except perhaps the small trading commission on an ETF). While you can always sell individual bonds on the secondary market, many corporate, provincial and municipal bonds are not highly liquid and may have high bid-ask spreads.

Simplicity. Index funds and ETFs eliminate the need to choose individual bond issues, some of which include embedded options that are difficult to understand. Funds also conveniently reinvest all interest payments so you can take full advantage of compounding. (This is harder with ETFs, but Claymore and BMO do offer dividend reinvestment plans.)

Cost. Some investors say they prefer to avoid fund fees, seemingly unaware that buying individual bonds also carries costs. It’s difficult to know just how much mark-up you’re paying, as the bond market is far less transparent than the stock market, since bonds trade over-the-counter rather than on an exchange.

In his book In Your Best Interest, Hank Cunningham says the average markup on bonds is 1%, and points out that this fee is payable only once, while bond funds may carry fees of 1.5% or 2% every year. But Couch Potatoes know better than to pay those ridiculous MERs. Bond index funds and ETFs are among the cheapest in any asset class, with MERs as low as 0.10%. With fees this low, any cost benefit of buying individual bonds shrinks dramatically, and many investors will accept the small fee in exchange for the benefits outlined above.

Like all investment decisions, there’s no one right answer here. Building a ladder of individual bonds is a perfectly good strategy, particularly for income-oriented investors with a six-figure sum to invest, a good knowledge of bond features and access to a low-cost broker. But for Couch Potato investors who are in the accumulation phase of their lives, a low-cost bond index fund or ETF can deliver market returns far more easily.