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“Risk cannot be destroyed, only transformed.” – Corey Hoffstein talking to Meb Faber

This is especially true in the fixed income markets. While many will try and slice-and-dice risk up into various buckets the amount of risk in a bond, or the bond markets as a whole, is pretty much fixed. That is why I find debates like the one about the relative attractiveness of individual bonds vs. bond funds exhausting. Apparently, Cliff Asness, writing in the Financial Analysts Journal, does as well:

“Many advisers and investors say things like, “You should own bonds directly, not bond funds, because bond funds can fall in value but you can always hold a bond to maturity and get your money back.” Let me try to be polite: Those who say this belong in one of Dante’s circles at about three and a half (between gluttony and greed).”

As noted earlier risk cannot be erased it can only be transferred (or hidden from plain sight). As Cullen Roche at Pragmatic Capitalism recently noted on the topic:

“A lot of people argue that individual bonds are safer because they can be held to maturity, but a bond fund is nothing more than the summation of all the individual bonds it holds. So, you’re getting greater diversification by reducing the single entity risk in the portfolio, but because you’re diversifying the portfolio you’re blending the maturity date so that the portfolio is constantly being rolled over across time.”

A bond fund is just a collection of bonds. If that collection of bonds does not fit with your particular risk profile don’t buy it. What I think is way more interesting about this debate is the behavioral aspect of owning individual bonds vs. owning a bond fund. Cullen Roche again:

“I would argue that the bigger risk with owning bond funds is that you can see their price daily. While this is also true for individual bonds it’s far less transparent and generally harder to find. In the world of indexing and ETFs we can log-in and check the price of any fund we like. This creates increased behavioral risk in bond funds because the volatility is more noticeable even though the same exact thing is happening in the individual bonds.”

Yes, individual bonds are priced daily. (Good luck finding the price.) Then again, brokerage-sold certificates of deposit (CDs) are priced daily as well and you don’t see a lot of people day trading them. The issue isn’t bond funds vs. individual bonds. The issue is what instrument puts in you the best position to not shoot yourself in the foot.

For the longest time, I thought target-date maturity bonds ETFs were the solution. They combined the diversification of bonds funds with the maturity of individual bonds. Compared to the rest of the ETF space they really haven’t taken off, although three Guggenheim BulletShares have amassed each more than $1 billion in AUM.

A less publicized solution, by two smart writers on the topic of investing, is to focus on buying CDs. I know, it certainly sounds boring, but investing isn’t supposed to be exciting. One reason why you don’t hear about the topic much is that there isn’t much money to be made selling CDs. Larry Swedroe writing at notes the generally dismal return premium investment grade corporate bonds have generated relative to Treasuries. Swedroe writes:

“However, the historical evidence suggests investors may be best served by excluding corporate bonds from their portfolios, instead using CDs, Treasurys and municipal bonds as appropriate (given their marginal tax rate).”

In this light the credit, for the individual investor, CDs look pretty good. Swedroe goes on in other posts to talk about the use of CDs in laddered bond portfolios and in relative to TIPs. Another advocate of CDs is William Bernstein who is his book, Rational Expectations: Asset Allocation for Investing Adults, excerpted here at Abnormal Returns wrote:

A reasonable fixed-income allocation for a largely sheltered portfolio might be equal amounts of CDs and Treasury bills or notes. A largely taxable portfolio might be equal parts munis, CDs, and Treasuries.

Bonds and bond-equivalents, like CDs, are there, by and large, to balance out your portfolio. In short, reduce risk. If you are a risk-seeking, 25-year-old with a 50-year investment horizon this discussion was not for you. The point is that investors should try to generate fixed income returns in a fashion that fits both their risk profile AND their behavioral needs. As weird as it may sound CDs and directly purchased Treasury bills, notes and bonds may accomplish this better than a bond mutual fund or ETF.

Does that mean they won’t fall in value in the event of a sharp, sustained rise in interest rates? Of course not. You should be holding sufficient liquid funds, i.e. money in the bank or money market mutual fund, to take through periods of market volatility. However, an eye on how you allocate your fixed income risk among different bond buckets, from a behavioral aspect, can make a difference. Remember the Fed isn’t the enemy of your portfolio, you are.

*Update: The Oblivious Investor makes the case for disaggregating your target-date fund and using CDs for the fixed income portion of the portfolio.

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