I was forwarded an article by Jane Bryant Quinn from 2011 arguing that individual bonds are generally a bad deal. She aptly notes that many bond ladders are inappropriately sold to investors by stock brokers, which I agree with, but many of her conclusions as to why bond ladders are bad are based on faulty assumptions. I’ll selectively cover her comments, since a few were already covered in my blog post from last week.

Bond ladders deprive investors of income
Jane makes the statement that mutual funds can generate more income since they can add “higher-rate bonds to the pool” if rates have gone up. The mistake here is confusing coupon rate with yield. Bonds with different coupon rates can and do trade at very similar yields. When comparing bonds, investors should focus on yield and risk, not coupon rate.

Buying higher coupon bonds and spending that income is effectively spending principal. Investors who believe they have somehow magically created more income in any meaningful sense by replacing low coupon bonds with high coupon bonds are kidding themselves. If you spend that “higher income,” all that you are doing is spending down the principal value of your bond portfolio.
 
Bond ladders deprive you of future capital gains
If I had one fixed income wish that could be granted, it would be to help investors understand that you don’t “lose” capital gains by holding bonds to maturity. When rates go down, bond prices go up, and some investors (including Jane) believe they must sell the bond or the gain goes away. That’s not right. In reality, gains can be captured in one of two ways:
  • First, you can sell the bond to capture it.
  • Second, you can hold the bond to maturity and capture the gain through higher interest payments, since the entire reason a bond would have a capital gain is because its coupon rate is higher than the rate the market currently requires. 

Here’s one other way to think about it: Let’s say I sell a bond at a gain but buy the exact same bond back. How could I possibly be economically better off by doing this instead of just holding the bond to maturity? In fact, you’re likely worse off because you incurred trading costs and potentially taxes to capture the gain.

Bond ladders carry more default risk
This statement is roughly equivalent to saying “all bond mutual funds hold risky investments.” We know there are a wide range of bond mutual funds. Some are risky because they hold high-default-risk bonds, while others hold much safer securities like Treasury bonds. The same is true of individual bond portfolios. They can be built with low-risk bonds or high-risk bonds. You can’t make a general statement that they always carry more default risk.

As I noted at the top of the post, I know JBQ directed many of these comments toward broker-built bond portfolios, but some of the statements aren’t valid critiques of any form of individual bond portfolio, broker-built or otherwise.

Random Links and Commentary of the Week
Here’s a great post from Professor Raghuram Rajan on current monetary and fiscal policy and its potential impact on economic growth.

And here’s a geeky NBA basketball story on the Bulls strategy for defending the two-man pick-and-roll game.

 This commentary appeared February 6 on Jared's blog at Multifactor World.

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