Bond Funds vs Individual Bond Breakdown and Why Your Retirement Strategy Might Be All Wrong

Today I’m going to go through some of the high-level differences between individual bonds and bond funds. Now this video is inspired from the one we did last week where we got a ton of comments. I think we had 16,000 views in just the first few days and almost 50 comments. I think maybe a little more than 50 comments. Not only am I going to touch on some of the high-level differences between individual bonds and bond funds, I’m going to go back to the last video, go through the comments section, and answer some of your questions directly.

What is an individual bond?

Very first thing to understand, that an individual bond is essentially a note or a loan from a government or a corporation to an individual or some type of entity, and that loan is the bond itself. That is what an individual bond is. When investment managers take multiple different individual bonds and group them together in a fund, that’s what a bond fund is. We have different types of individual bonds. You have government bonds. You have corporate bonds. You have short-term. You have intermediate-term. You have long-term bonds. Then that transfers over to the bond fund world as well.

A long-term bond fund is going to be a grouping of a whole lot of individual long-term bonds into that one fund. Just wanted to get the basics out of the way so we understand at a high level the difference between individual bonds and bond funds. Now when we’re looking at individual bonds, I wanted to touch on some of the terminology that you should be aware of. Most bonds, when they issue, they have what’s known as a par value. Typically, that’s going to be $1,000.

Whatever a bond’s par value is, when it matures, so if it’s a 10-year term, when that 10th year comes, if the corporation or government is still solvent, they are promising to repay you the par value of that bond. In this instance, it would be $1,000. Once bonds are issued, they start to trade on the secondary market. Just like anything else on the secondary market, stocks are the best example. Your individual bonds fluctuate in price. They can fluctuate based on how the company’s operating performance is going.

Key terms: Coupon, Yield, Maturity and Yield to Maturity (YTM)

If the company is gathering a lot of debt, profits are going down, typically that bond’s price will go down because it will be less favored due to the poor operating results. Also, interest rates can impact a bond’s price. We’ll get into that a little bit later. I’m showing an individual bond here. The first thing we want to be aware, of course, is the par value, which typically is going to be $1,000, but the very next thing is the price. What is the price? What is it currently trading at? What is the coupon?

The coupon, if it’s 3%, to do that math of how much interest you’ll earn, you have to take this coupon, and you don’t multiply it by the price, you multiply it by the par value. In this instance, if it has a coupon of 3% and a par value of $1,000, that’s $30 of interest that one bond will pay. It has a yield of 3.33. That’s because the interest that we’re going to receive, the $30, if we can buy it at 900. The yield we don’t calculate off the par value.

We calculate the yield off the dollars that we will receive divided by the price that we can purchase it at. The coupon is what the bond pays based on its initial offering, the 3% divided by 1,000. That’s $30. The yield that you will receive is based on the point in time or when you purchased the bond. If you’re going to get $30, you divide that by the price, your yield is 3.33%.

The next thing you should be aware of is the maturity. Here, this is a hypothetical bond, but I wrote down a six-year maturity. That means if this corporation or government is able to repay you in full at the end of the six-year term of what’s remaining on this bond, then you will get $1,000 back. You will collect $30 of interest annually. By the way, that’s typically paid every six months. Bond interest is typically paid semi-annually, but not always. Six-years left.

This bond, let’s say it was a 10-year bond when it was issued, but now it’s out there trading in the overall market. There’s six years left to maturity. You could go out, theoretically buy this one for $900. It would pay 3% off the $1,000, which is $30. Your yield will be 3.33%. You’re going to hold that for six years and receive that $30 of interest in total over the course of the year, typically broken up two payments of $15 in six-month increments.

Now we have this concept called yield to maturity. One of the comments in the previous video that I did that I’m going to highly recommend you watch after this one asks, why don’t we consider the price discount? This is going to be known as a discount bond because it’s trading at a discount. If I can buy it at 900 and when it matures, if I get back 1,000, why isn’t that included in the calculation? It’s not here. It’s not here. It’s in what’s known as the yield to maturity.

The yield to maturity also takes into consideration the time left before the bond matures, because it’s looking at the present value of all the future payments that you will receive from this bond. The number that truly matters, if you plan on holding this bond for six years, is this yield to maturity because this is taking into consideration the capital gain that you will receive if the company is able to repay the $1,000. You buy it at 900. You’re going to collect a yield of 3.33% until it matures, and then when it matures, you’ll have a $100 capital gain. When we take into consideration the present value of those future payments that we will receive, that comes up to 4.95% per year. That’s what yields maturity is.

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What to know about Callable Bonds

Now, the next three terms that you should be aware of are credit quality, duration, and is the bond callable. A lot of people don’t understand the difference. It’s a line of demarcation here to where if it’s triple B or above, it’s considered investment grade. If it’s double B or below, it’s considered a high yield. Otherwise, a lot of times known as a junk bond. Duration is one of those concepts in the bond market where now we’re starting to go down a rabbit hole, but it is something that you should understand.

When we get into the conversations about duration and also something known as convexity, they’re important because they help you understand how your bond’s price is impacted by changes in the interest rate environment. I don’t want to go too far down this rabbit hole, because this is where it really does start to get tremendously complex. In simple terms, duration is it helps you understand. If five years is the duration for your bond, if interest rates go up 1%, you could expect about a 5% decline in your bond’s price. That’s the sensitivity to interest rate changes.

The last thing to know is your bond callable. Here I just wrote “No.” It just means the corporation can’t call that bond in. It could be yes or no. If the bond is callable, the important thing to understand is that at any point in time, if it’s advantageous to the corporation, they can call that bond back in. If it’s an investment-grade bond, typically it will be called in at par value, which could be a good thing for you. If you bought it at 900, it gets called the next day, yes, you didn’t receive your 4.95% yield to maturity, but you had it for one day.

You bought it for 900, it gets called, then you receive 1,000. You made $100 divided by your 900. You made a pretty good return for holding it just one day. The corporations are typically going to call bonds whenever it’s in their best interest. Just be aware of it, because if you’re planning on this 4.95% and it gets called, if it’s a high-yield bond, there may be a call schedule, a price schedule. Just be aware. Is it going to be called? What do you get paid? What are the terms surrounding that? You just want to be aware of that.

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What are Bond Funds?

I’m going to transition to bond funds now. If you have specific questions about individual bonds, put them in the comments below. We’ll try to answer them. If we get a lot, maybe I’ll do a response video or like this video. I’ll do a topic that comes from the comments section and also go back and do some of the comments directly in that next video. A lot of these concepts are similar to what we just went through, because a bond fund is nothing more than a grouping or a basket of individual bonds.

What we’re going to see here when we look at yield, we don’t have to worry about a yield to maturity because bond funds never mature. When we see a yield, if it says 2% or 3%, that’s what you can expect to earn because that’s what it’s paying based at the time that you’ve made your investment. Now, instead of duration, we have average duration because there may be 100 or 1,000 individual bonds inside that bond fund. They’re all going to have their own different duration. You have to look up what is the average duration.

Now, I’m going to go through a couple bond funds on Yahoo Finance in a minute. Yahoo used to keep the duration for bond funds, the average duration on their profile, but I don’t see it anymore. You may have to Google that. It is something that you need to know, because that, again, helps you understand the impact interest rate changes have on the price of your bond. Holdings. What type of bond fund am I purchasing? What are the individual bonds that make up the fund? What are the sectors, the parts of the economy that it’s invested in?

Is it consumer discretionary? Is it cyclical? Is it technology? Is it a diversified bucket of individual bonds or is it highly concentrated into one particular sector? Are they public? Are they government bonds? Is it private corporate bonds?  We want to understand what is comprised or what makes up that bond fund.

The next three things are credit quality, what is the expense ratio, and then the price history of that bond. Expenses, a lot of times with expenses, Vanguard has marketed this for years that expenses are really important. I don’t want to diminish expenses, but just like anything in this world, you get what you pay for. If you eat bread, for example, you can get very, very cheap bread if you go to the bread aisle and you get the white wonder bread that a lot of us grew up eating. That’s very cheap bread. You can get that, I don’t know, probably $1 a loaf today, or you can get whole wheat, higher quality. Even if it’s white bread, you can still get a much higher quality from the bakery. It’s going to cost more.

You don’t always want to necessarily go for what has the least expense, but understand what is the value that I’m receiving. If you see a bond fund that has 0.5 and one from Vanguard that’s 0.02, it shouldn’t necessarily sway you in one direction or another. It’s just a piece of information. What else are you getting for this increased expense? I see that a lot, where people sacrifice quality for low price, but they don’t really have an understanding of what it is that they’re getting or what they’re buying, and they’re leaving a lot of value on the table. Just be aware of that.

Now I have price history here because I didn’t want to get into some of the fancy terms for looking at risk and volatility. All you really have to do is look at the price history, open up the chart of that bond fund, and if it was trading at $30, is it now trading at $20? If so, it has pretty good volatility, and that bond can go down in price pretty significantly. That’s what I mean with price history. Just open up a chart and see how has it performed over the past one, three, and five years, so you can have an understanding of what the shorter-term or intermediate-term volatility you could expect might be.

Now what we have is I pulled up on Yahoo Finance a Vanguard Intermediate-Term Corporate Bond Index. Just some of the things we just went through, I want to show you them and also dive into a little bit more of the differences between individual bonds and bond funds. When we look at, this is VCIT– I do want to make sure that I put the disclosure out there that this is not a recommendation, we’re not endorsing this bond fund, I’m not advising you to buy it.

Example of a Bond Fund

This is an educational example that I want to go through and help tie together a lot of the information that we just covered on the whiteboard so you can actually see it in an interactive fashion that maybe you can utilize at home when you’re doing some of your own research. First thing I’m going to come down here and look at is what is the current yield? 4.43%, year-to-date daily total return, -0.51. I’m recording this video in January 2025, so that’s not too important to me.

Something else I’m going to want to know, volume. This is the trading volume, so 7.1 million shares, an average of 6.4. All that means is that it’s very liquid. If I wanted to sell this at any given time, I’d have no difficulty. You’d expect that with pretty much any Vanguard fund. Here we have the 52-week range, so this gives us an idea of that price history. Over the past year, what has been the range? How much fluctuation would I expect to see in my principal? Expense ratio, 0.04%.

One of the big points to understand is when you have an individual bond, it has a set maturity date. When you have bond funds, it doesn’t have a set maturity date, the fund itself does not, but the individual bonds inside the fund do. Let’s first look at the five-year price history. We see this fund has lost 12% of its value over the past five years. Most of it has happened in the past three, and I don’t know if it’s technically considered a bond bear market, but bonds have done quite poorly over the past three years.

Bonds have really done pretty bad over the past 15, 16, 17 years, really coming out of the financial crisis from 2010 on. Bonds really have not performed tremendously well, high-level speaking. We see this price volatility, though. If you bought it here, and let’s say the yield was 4.5%, and it goes down, so it was trading at around 95, maybe as high as 100 back in 2021, and it got down over here, we’re down below $75, so it lost about 25% of its value in about a year or two.

First thing to ask yourself, are you comfortable with that level of volatility in your fixed-income portfolio? Because most people invest in bonds because they are less risky. You have to understand less risky does not mean no market risk. It means your principal can still go down in value. Let’s make sure we’re comfortable here. Now, sometimes we get the question, if this one’s paying 4.5%, can I expect it to continue to pay 4.5%? Also, when do I receive those payments? Because individual bonds, they paid semi-annually most typically.

The example we used was a $30 payment. You would expect to receive half of that in the first six months and half of that in the second six months. The yield that you see, that’s always an annual yield. With bond funds, you would expect to receive the payment either typically monthly, quarterly, or semi-annually, or I guess possibly annually as well. That is something that you would want to look at, is what is the fund payout date? Mutual funds, ETFs, index funds, you can find their payout date to when you can expect to receive those payments.

Understanding bond fund income and risks

Now, the actual interest rate itself, so if you bought it now in January 2025 and interest rates go down, like many people would expect over the next four, five, six, seven years, then as the individual bonds that were purchased now in today’s higher interest rate environment, as they mature, the manager takes those cash proceeds and reinvests into a lower interest rate environment, we would expect the yield on this fund to go down even further. Regardless, as long as you own it or had purchased it and it was paying around that 4% yield, if it’s more intermediate term, I would expect you to receive that income for a few years because bonds that were purchased in this higher rate environment, they should have been purchased with 4, 5, 6, 7, 8, 9, 10 years.

The trade-off, of course, for the intermediate term is you’re going to see more price volatility, or at least you should expect more price volatility. Your principle could fluctuate in value a lot more significantly than the short-term fixed-income options. Now, we did this in pretty good detail talking about the difference in yield, price reaction to interest rate changes in the first video. Again, so much we covered in that first video, I really encourage you to go back and check that out.

We got a little bit into the woods there towards the end of that explanation, but hopefully, that was helpful for you. Now, I want to go back. I’ve been referencing the video that we did, the introduction to bonds video. Here it is. Understanding Bonds for Retirement: Basics, Market Insights, and How Brokers Get Paid. You can find it on our YouTube channel, or I imagine we’ll probably have a link or somewhere you can click once this video is over. What I want to do is go through some of the comments now and provide some responses, because if you watch that one, there’s a good chance you’re watching this one. If you want to read it, I can provide you an answer now.

Tanya, I’m not going to read it, but she’s basically saying that things in retirement haven’t worked out the way she wanted. Typically when we see this, Tanya, it’s because there’s no plan. If you’re just buying stocks and just buying bonds, what’s happening is you’re not creating visibility. How do these different tools work together to generate income, to keep my risk down, to help me pay less in tax, and make sure that if something happens to me, my family is okay. That’s really what the planning part of retirement is. It’s not just buying these different tools, because without the plan, it makes it hard to stick with those tools when things don’t go in the right direction in the short term. You need a plan.

Then we get a lot of good complimentary comments here. Really, thanks, guys. We really do appreciate the kind words.

@GotGrace says I switched from bonds to bond funds smoother than a three-card Monty dealer. Actual bonds, held to maturity, do not go down in value. Yes, they do. We went through, we covered this. Individual bonds, even if held to maturity, in the interim, they fluctuate in value. They can fluctuate in value significantly. Now, once they mature, yes, they typically will repay back their par value, which is normally $1,000. Very important to understand here, you may not look at it every single day like you would a bond fund, because they’re just a little bit more difficult to look at individual bonds on your statements and understand the differences. They absolutely go down or up in value.

Donald says that this is his fifth year of retirement, been following the 4% rule. It’s on YouTube, but it’s not really going the way he wanted to. We have a lot of videos on the 4% rule. We are not fans of the 4% rule. It’s just too general. Again, you need a plan. You need something more tailored to your particular circumstances. A lot of times, people are leaving too much money on the table by following the 4% rule. Also, in your particular situation, if something’s not working out, you probably don’t have a plan and you’re probably misallocated. Your risk in your portfolio is probably different than your willingness to take risk. When you have a misallocation there and something happens, like 2022, you may have made a bad decision, which now has put the portfolio value in a precarious position. Have a plan, but make sure you’re in alignment with your willingness to take risk and the actual risk that you actually have.

Market insights and broker considerations

OptionsForLongTermInvestors says, “Great content, thanks. More please, especially about transaction costs of bonds and best brokerage for consumers.” Transaction costs, this is just an area of the bond market that’s extremely opaque. You have broker-dealers, so brokers are the one that do the transactions, but dealers are the one that hold the bonds. A lot of times if you’re buying from Fidelity, for example, they’re the broker and the dealer. They own the bonds, they have their own inventory, and they may have it in the market at a certain price, but Fidelity only shows you this price and they’re making this spread.

It’s very, very opaque. A lot of times when you’re doing it yourself, you have no way to identify what the true costs are. One thing I will say, so I used to have an account with Interactive Brokers and Fidelity. When I would look at bond prices, same exact bond, same everything, Fidelity sometimes would be $3, $4, $5, $6, $7, maybe even $10 higher on the prices that I could purchase those bonds at. Interactive Brokers may be a place to consider. Again, not endorsing them, they don’t pay me any money, but I would maybe recommend checking them out, doing some of your own investigation.

Jim, I really want to appreciate your comment here. He says, “Thanks, Troy. If you do a follow-up video, can you explain the difference between individual bonds and bond funds?” This is the inspiration for today’s video. Thank you very much, Jim. Hopefully, today was helpful for you. Andrew says, “Great explanation. Do you have or would you consider doing a video on the advantages, disadvantages of using TreasuryDirect versus an online broker?”

Yes, TreasuryDirect you’re going to buy directly from the United States government. I don’t believe there’s a secondary market there. You may be able to, but you would be buying them, I believe, new issue bonds from the Treasury. I’ve never done it myself personally versus using an online broker. If you find a good online broker that has some transparent pricing, it’s going to be far more easy typically to purchase them and sell them. Again, it comes down to value versus cost. Yes, you’re going to save a little bit if you go through TreasuryDirect, but is that the value? Where are you at in that value spectrum? Just understand that.

Individual bonds, bond funds, and bond ETFs. Appeal2008, hopefully, this video, again, we had several comments along this same vein. Thank you very much. It helped us come up with today’s video. You touch upon bond funds, “They look like terrible investments. Could you give more insight?” Again, they’re just tools. Just like anything, they’re meant to be used as part of an overall plan. We don’t necessarily say they are good or they’re bad. We look at everything as a tool. People say the same thing about annuities. They’re horrible. They’re awful. We look at them as a tool. All of these different tools, if used appropriately and in the appropriate percentage, can have a role to play as part of a broader plan.

Again, would I put my money into bonds, all of my money into bonds? No, I would not. I’m working, I have an income, and I don’t care about risk. I’m different. For everyone’s situation, you have to have a bigger plan and understand these are some of the tools that are available. I just don’t want you to misuse the tools that we see happen all the time. Thank you for tuning in. I hope this was very educational and helpful to you in understanding bonds a little bit better. Make sure, again, to click on the video up there, hit the card, because the first video we did is a good primer for this one, but they go really well together. I encourage you to check out that video.

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