Bonds: Funds or Ladders?

If you have read our investment philosophy, you know that bonds (also known as fixed income) play a critical role in our portfolios. They serve to minimize loses during inevitable market declines, provide predictable income for reinvestment or cash flow, and are a stable source of funds to strategically purchase equities when prices are clearly cheap.

There are two ways we add fixed income to a portfolio: direct purchases of individual bonds, or the purchase of bond funds (a diversified pool of individual bonds packaged as a mutual fund or ETF). We have a solid preference for owning individual bonds with laddered maturities (a bond ladder), but also use some funds. Here’s why…

Feature Bond Ladder Bond Fund
Minimum Investment $250,000 minimum investment typically required Minimum investment is usually low to none
Diversification Low: 10-30 individual bond positions depending on portfolio size High: Hundreds of individual bond positions held inside the fund
Costs 0.15% to 0.30% for trading and ongoing credit analysis 0.10% to over 1.0% fund expenses based on management style and types of bonds
Credit Risk (Default Risk) Monitoring credit risk of each bond is critical since diversification is low – a single default can have a large impact on the portfolio, so bond ladders are usually limited to high quality bonds Unsystematic credit risk is minimized through high levels of diversification
Interest Rate Risk Since individual bonds can be held to maturity, interest rate risk is eliminated over the full holding period, but interim price changes will still be observed in the portfolio A bond fund has no set maturity, and managers are often forced to sell individual bonds before maturity, so interest rate risk persists consistent with the duration of the underlying holdings
Income Stability The process of rolling matured bonds to the end of the ladder each year results in a highly stable and predictable income stream Income will vary based on the changing composition of the underlying holdings over time
Best Use Core fixed income allocations such as municipal, corporate and government bonds whenever the minimum investment can be met Strategic allocations to international, high yield and emerging market bonds, and core allocations when the bond ladder minimums can not be met