Bond Funds Aren’t Naturally Riskier Than Individual Bonds

In spending significant time talking to clients and wealth advisors about fixed income, one common misconception is that bond funds are more exposed to interest rate risk than laddered individual bond portfolios. The logic basically starts and ends with the observation that individual bonds can be held to maturity while bond funds don’t necessarily hold all bonds until they mature. Because all individual bonds can be held to maturity, as the logic goes, it doesn’t matter if their prices go up or down in the interim. This does indeed sound logical, but as it turns out, laddered individual bond portfolios and bond funds with similar-maturity bond holdings have almost identical exposure to interest rate risk. There simply isn’t much of a difference, yet the incorrect point of view is all too common within the industry and can lead investors to take excessive interest rate risk in individual bond portfolios without understanding the implications.

Comparing Returns and Volatility

I’ve found the best way to illustrate my point is with real-world data comparing the returns and volatility of a laddered bond portfolio with a hypothetical bond fund portfolio. In my example, I construct a laddered bond portfolio by allocating equal investment dollars to bonds maturing from one through 10 years. At the end of each year, the portfolio effectively invests the proceeds from the one-year bond that matured into a 10-year bond and repeats this process each and every year. This is a good proxy for how bond ladders are actually constructed in practice.

Separately, I construct a “bond fund” portfolio using three-, five- and 10-year bonds, with this portfolio constructed to match the duration and convexity (the two primary measures of the interest rate risk in a fixed income portfolio) of my laddered bond portfolio. Each year, the bond fund portfolio reallocates among its three choices to match the duration and convexity of the laddered bond portfolio. Note that none of the positions in this second portfolio ever mature.

If laddered bonds are truly safer than bond funds, these two portfolios should have significantly different risk-adjusted returns. The table below shows the average annual returns and volatility of both portfolios over the period of 1993 through 2013, which is the longest data set I had to work with.

BAM

As the data shows, the returns and volatility are virtually identical. At the end of the day, that’s basically all that matters.

Note, however, that individual bonds can still have advantages relative to bond funds. It’s just that those potential advantages have nothing to do with individual bond portfolios having less interest rate risk than bond funds. I covered the potential advantages and considerations in a previous blog.

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