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InvestmentCounseling& Research / A N A LY S I S Taxable Bond Investing: Bond Funds

or Individual Bonds?

Executive Summary For most taxable bond investors, bond mutual funds have a number of advantages over

individual bond portfolios in terms of diversification, cash-flow treatment and portfolio characteristics, liquidity,

and costs. Individual bonds do provide certain benefits compared with bond mutual funds, and these

advantages revolve primarily around a preference for control over security-specific decisions in the portfolio.

The cost of this advantage can be thought of as a “control premium” that is reflected in generally higher (or

additional) transaction costs, lower liquidity, more limited return opportunities, and higher bond portfolio risk.

The cost of the control premium is more pronounced for buyers of corporate bonds and mortgage-backed

securities than for buyers of U.S. Treasuries.

Introduction This paper primarily examines the advantages ofbond mutual funds over portfolios of directlyheld bonds for both institutional and individualinvestors. First, we review the structural advan-tages of bond mutual funds, which, comparedwith separately managed and laddered portfoliosof individual bonds, generally provide greaterdiversification; more regular cash flows thatpromote stability of portfolio characteristics;better liquidity; and lower transaction andoperating costs. Second, we explore the uniqueadvantages of a mutual fund portfolio in threediscrete sectors of the taxable fixed incomemarket: corporate bonds, mortgage-backedsecurities, and U.S. Treasury bonds.

The paper’s final section describes the lim-ited situations in which a portfolio of directlyheld bonds can provide advantages over a mutualfund. We characterize most of these advantagesas “control” benefits, and refer to their poten-tially higher cost as the “control premium.” Thiscontrol becomes more limited when consideringbonds with options, such as corporate and mort-gage-backed securities.

It is important to note that the main areas inwhich a mutual fund exhibits advantages over aportfolio of directly held bonds are ones that havea marked impact on a bond portfolio’s risk-and-return characteristics. For a portfolio of directlyheld bonds, on the other hand, the control advan-tage is primarily driven by preference.

To help frame some of the concepts dis-cussed in this paper, we begin with a primer onbond pricing. We want to emphasize, first, thecommon misconception that there is a benefit toreceiving principal back at maturity. If that prin-cipal is simply reinvested and not used to fund a cash flow, there is no benefit in holding a bondto maturity. Consider that the total return of a laddered1 separate account with characteristicsidentical to those of an open-end mutual fundwill deviate from the fund’s return only by thetransaction and operational cost differentials.

®

MARCH 2005

Scott J. Donaldson, CFA, CFP®

1 Portfolio structure in which approximately equal amounts of dollars are invested inindividual bonds with increasingly longer maturities.

Bond Pricing Regardless of the type of bond, the pricingprocess uses the same formula:

Where:P0 = Price of the bond;CF = Expected coupon interest (in $) and

principal repayment (in $);M = Maturity value (in $);n = Number of periods;y = Yield to maturity.

This formula outlines the factors that influencebond prices: the coupon (CF), the value at matu-rity (M), and the number of periods that thebond will earn interest (n). The price of anyfinancial instrument is determined by the pres-ent value of the cash flows from the investment.Discounting back to the present value takes thetime value of money into account and utilizes themarket rate of return (represented by y in theabove equation) for holding such financialinstruments. For a bond, these cash flows are theperiodic interest and principal payments plus thematurity value.

A bond’s price is inversely related to thechange in interest rates: when interest rates rise,a bond’s price falls. This is because a bond’scoupon payments are typically fixed at issuance,leaving the price as the only variable that can

adjust to make an existing bond’s yield competi-tive with that of newly issued bonds. Thus, wheninterest rates change, the price of each bondadjusts so that comparable bonds with differentcoupon rates provide the investor with the sameyield to maturity. When evaluating bonds withthe same characteristics but different couponpayments, it is therefore always best to comparethe yield to maturity of each bond. This is illus-trated in Table 1.

If 15-year bonds are currently yielding 6%,the price of a 4% bond—to be competitive—must decline to a level that results in a 6% yieldto maturity. In the example in Table 1, the priceis 80.58% of face value (or $805.80 per $1,000face value). The 4% bond would provide thesame return as the 6% bond at par, but some ofthe return would come from the bond’s appreci-ation from $805.80 to its $1,000 value at matu-rity, as opposed to the coupon payments.

This example also illustrates why investorsholding discount bonds are wise not to try to“trade up” to current-coupon bonds. Since the 4%bond’s price has already adjusted to compensatefor the lower coupon, from that point forward theyield to maturity would be the same—6%—whether an investor holds the 4% bond tomaturity or buys the 6% par bond. Since theyield-to-maturity calculation does not incorpo-rate transaction costs, an investor’s yield wouldactually be lower if the 4% bond were sold andreplaced with the 6% bond than if the 4% bondwere held to maturity.

Vanguard Investment Counseling & Research 2

CF(1+y)2

CF(1+y)3

CF(1+y)n

. . . ++= +P0+ + M

(1+y)n

CF(1+y)1

Table 1

When Evaluating Bonds, Compare the Yields to Maturity

Taxable Bonds With 15 Years to Maturity

Coupon (annual interest payment) 9% 6% 4% 0%Price (percentage of face value) 129.14% 100% 80.58% 41.73%Yield to Maturity 6% 6% 6% 6%

Source: Vanguard Investment Counseling & Research.

A Mutual Fund’s Structural Advantages Once an appropriate allocation to bonds hasbeen determined, a decision must be made as tohow to implement the investment strategy.The options include a professionally managedmutual fund, a professionally managed separateaccount, or a self-directed portfolio of individ-ual bonds. The mutual fund structure generallyprovides an advantage over separate and self-directed accounts in terms of diversification,cash-flow treatment and portfolio characteris-tics, liquidity, and costs.

Diversification

Bond mutual funds typically provide broaderdiversification as to issuers, credit qualities,maturities, and bond characteristics (callable ornoncallable, senior or subordinated debt, forexample) than is possible with alternativeaccount structures. This greater diversification ispossible because a bond fund generally has alarger pool of investable assets, along with theprofessional staff needed to conduct thoroughanalyses of individual securities and marketcharacteristics, thus allowing a fund manager todiversify widely and cost-effectively. Althoughdiversification can never eliminate the risks ofinvesting, broad diversification reduces the non-systematic (and, in theory, unrewarded) risk thatcomes from owning either too few securities orsecurities with similar characteristics.

Cash-Flow Treatment and Portfolio Characteristics

A mutual fund allows for both timelier imple-mentation of an initial bond investment andtimelier reinvestment of interest payments.Because of their more-regular, ongoing cashflows, mutual funds are also better able thanalternative vehicles to maintain more-stableportfolio risk characteristics over time. The fundstructure furthermore facilitates liquidations,especially partial liquidations, without compro-mising the portfolio’s risk characteristics.

In a bond mutual fund, an investor can pur-chase a proportionate share of a completely con-structed portfolio with a single transaction. Anindividual bond portfolio, by contrast, typicallytakes time to build. Mutual funds also allow thetimely investment of additional cash flows (bothincome payments and new cash flow). Bondmutual funds pay monthly dividends to theirshareholders based on each client’s proportionateshare of the interest received by the fund fromthe individual bonds that it owns. Investors canopt either to have these dividends paid out tothem or to have them automatically reinvestedinto the fund. In a separate account or self-directed bond portfolio, cash from bond-couponpayments (assuming reinvestment) or new in-vestments may need to accumulate until it issufficient for a round-lot purchase and/or untilthe bond of choice is available. Because the yieldcurve is typically upward sloping, bonds havehistorically produced higher returns than cashinvestments such as money market instruments(the most common “parking place” for moneythat can’t yet be invested). A mutual fund’smore timely investment of new cash and rein-vestment of income can reduce the “cash drag”on performance.


Sources: The Vanguard Group, Inc.; derived from data provided by Lehman Brothers.

Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Figure 1

Capital return = 10%; 3% of total index return

Income return = 128%; 45% of total index return

Interest on interest total return = 149%; 52% of total index return

Growth of $50,000 in Lehman Brothers Aggregate Bond Index(December 31, 1986–December 31, 2004)

1988 1990 1992 1994 1996 1998 2000 2002 200430,000

50,000

70,000

90,000

110,000

130,000

150,000

170,000

190,000

$210,000

December 31, 2004Total interest on interest $74,377Total income 63,945Capital ending value + 54,819Ending value $193,141

July 31, 1989 Capital ending value $49,014Total income 11,028Total interest on interest + 1,769Ending value $61,811

As Figure 1 shows, reinvesting a bond port-folio’s income is critical to maximizing its long-term total returns. From December 31, 1986,through December 31, 2004, the compoundedtotal return earned on reinvested income for theLehman Brothers Aggregate Bond Indexaccounted for a majority (52%) of the index’sreturn for the period. The actual income distributions provided the other major portion (45%) of the performance. The capital return on the original $50,000 investment accounted for only a small amount (3%) of the performance.Therefore, NAV (net asset value), or pricechange, of a bond investment over a long timehorizon is not significant. During this period, themaximum decline in capital was approximately9%, and the maximum gain was about 13%.

An additional benefit of bond funds’ more-regular cash flows is that the funds can providemore-stable risk characteristics (most important,that of duration—a measure of the sensitivity of

bond prices to interest rate movements) thanthose of alternative structures. The duration ofladdered individual bond portfolios drifts downover time and jumps back up as cash flows arereinvested. Because these portfolios typicallyhold fewer securities, a larger percentage of theportfolio matures less frequently and gets rein-vested into the portfolio, potentially causingmore dramatic changes in the portfolio’s dura-tion. As stated, a portfolio with fewer bonds,which may also include concentrated positions,is especially prone to this effect. In a diversifiedmutual fund, however, cash flows are reinvestedmore frequently, and each maturing bondreturning principal represents a much smallerpercentage of the overall portfolio. This keepsthe fund’s risk characteristics more stable overtime.

Finally, a bond mutual fund also allows aninvestor to sell bond assets more cost-effectively,especially in the case of partial liquidations.Although liquidation of fund shares does notchange a bond portfolio’s overall risk profile, liq-uidations from an individual bond portfolio mayrequire selling a whole bond, which does alter theportfolio’s overall risk characteristics. To prop-erly maintain the portfolio’s risk profile, a smallpercentage of each bond would need to besold—obviously not a viable solution. In addi-tion, liquidating a portion of a position in a particular security can be expensive owing tobid–ask spreads and other transaction costs.

Costs

All bond portfolios incur costs. Mutual fundsand professionally managed separate accountsbear operating and transaction costs. A self-directed bond portfolio incurs only transactioncosts, but is subject to many other limitationsthat can be considered “opportunity” costs.These opportunity costs can also be a factor inseparate accounts. Investment costs associatedwith taxable bonds primarily fall into two cate-gories: management costs and transaction costs.


Management Costs. Both bond mutual fundsand professionally managed separate accountscharge ongoing fees to manage the portfolio.Bond funds charge an ongoing management fee(expense ratio) for fund-operating expenses.This expense ratio includes the cost not only ofportfolio management but also of legal, account-ing, custody, and recordkeeping services. Whileinvestment management cost is a widely recog-nized component of a fund’s expense ratio, theseadditional operational expenses are also impor-tant, though less frequently understood. Sep-arately managed accounts typically charge aninvestment management fee, as well as additionaladministrative fees for some of these same oper-ational expenses. Because the cost of these ser-vices is shared over a large asset base, mutualfunds can typically provide all of these services at

proportionately lower costs than can separatelymanaged accounts.

The annual expense ratio for the averagetaxable bond mutual fund is 0.58%,2 with fundexpense ratios ranging from 0.05% to 2.57%.Bond funds at the lower end of the cost spec-trum are readily available. For example, for a $10 million laddered Treasury mutual fundportfolio—constructed using low-cost, short-,intermediate-, and long-term share classesavailable—the annual expense ratio could be aslow as 0.15%, or $15,000. As illustrated in Tables2 and 3, investors commonly pay more for sepa-rate-account management.Table 2 reflects typical


Table 2

Typical Annual Investment Management Fees for Separate Accounts

Annual Fees by Account Size (in basis points)

$5 $10 $25 $50 $75 $100 $150 $250

10th Percentile 50 bp 50 bp 44 bp 38 bp 36 bp 35 bp 32 bp 31 bp90th Percentile 30 30 25 25 22 21 19 17Average 42 39 35 31 29 28 26 24Sample Size 106 189 235 258 265 266 266 266

Core Investment-Grade Accounts—U.S. Fixed Income (in $ millions)

Source: Global Investment Management Fee Study (Chicago: Mercer Investment Consulting, October 2004).

Table 3

Examples of Separate-Account Program Client-Fee Schedules (in basis points)

Fixed Income Accounts

Firm Type Breakpoint 1 Breakpoint 2 Breakpoint 3 Breakpoint 4 Breakpoint 5

Wirehouse* First $500k Next $500k Next $4 million > $5 million: flat rate N.A.125 bp 100 bp 80 bp or negotiable

Regional** First $200k Next $300k Next $2 million Next $2.5 million > $5 million87.5 bp 82.5 bp 77.5 bp 72.5 bp 65 bp

Source: Cerulli Quantitative Update: Managed Accounts 2003, Program Sponsors (Boston: Cerulli Associates, February 2004).**Large, national full-service broker-dealers traditionally based in New York. These include: Merrill Lynch, Smith Barney, Morgan Stanley, UBS PaineWebber, and Wachovia (included

based on its 2003 merger with Prudential Securities).**Full-service broker-dealer firms with a strong concentration of offices in one region of the United States—for example, RBC Dain Rauscher, Robert W. Baird, and Piper Jaffray.

2 Derived from Morningstar, Inc., data as of December 31, 2004, representing theasset-weighted averages of the Short-Term Bond and Short-Term Government;Intermediate-Term Bond and Intermediate-Term Government; and Long-Term Bond and Long-Term Government Morningstar fund categories.

Sources: Lipper Inc., Lehman Brothers, and The Vanguard Group, Inc.

Figure 2

Number of funds Lehman Aggregate Bond Index

Performance Distribution of Intermediate-Term Investment-Grade Bond Funds Versus Lehman Aggregate Bond Index: Ten Years Ended December 31, 2004

Return Difference (in percentage points)

Num

ber o

f Fun

ds

<–2

3

–2 to –1

38

–1 to 0

72

0 to 1

19

86% Worse (113 funds) 14% Better (19 funds)

0

10

20

30

40

50

60

70

80

Past performance is not a guarantee of future returns. The performanceof an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Table 4

Higher Expenses Tend to Result in Lower Returns

Average Average Expense Five-Year

Bond-Fund Category Ratio (%) Return (%)

Short-Term Corporate/GovernmentGroup 1 0.44 5.12Group 2 0.71 4.99Group 3 0.92 5.02Group 4 1.48 4.68

Intermediate-Term Corporate/GovernmentGroup 1 0.51 7.37Group 2 0.80 6.84Group 3 1.11 6.53Group 4 1.76 5.92

Source: Morningstar, Inc.Notes: For each category, constituent funds were divided into four equal groups basedon their expense ratios. Five-year annualized returns ended December 31, 2004.

points would reduce a 2% historical “real” bondreturn by 25%. Regardless of the structure, costsare important because they directly reduce thetotal return of a bond portfolio.

For fixed income investments as opposed toequity investments, costs tend to be a more sig-nificant performance drag. This is because of therelatively narrow range of returns between thebest and worst performers in the bond market.Figure 2 shows the distribution of ten-yearreturns for the 132 intermediate-term, invest-ment-grade bond funds in existence for thedecade ended December 31, 2004. As is typical,performance was concentrated in the middlebars of the figure. This narrow distributionoccurs because, with bonds, a large proportion oftheir returns is determined primarily by interestrate fluctuations and a lesser proportion by creditquality. Since these factors are common to allbond portfolios in a given market, the portfolios

investment management fees (additional costsmay exist for administrative expenses) for largeinstitutional separate accounts, while Table 3 is more reflective of fees paid by individualinvestors in managed separate-account pro-grams.

It should be noted that, in specificinstances, fees for some separate accounts may benegotiated lower. Tables 2 and 3, however, pro-vide examples of fee schedules two to three timeshigher than those of low-cost, professionallymanaged mutual funds. Considering that “real”(inflation-adjusted) bond returns historicallyhave ranged from 2% to 3% annually, high costscan eat a large portion of those returns. Forexample, increasing the annual cost by 50 basis


move together during rising and falling markets,resulting in a narrow distribution of returns.Fund expenses on their own can cause significantunderperformance relative to an index. Note that,in Table 4, the lowest-cost quartile in both theshort- and intermediate-term bond-fund cate-gories outperformed each of the correspondinghigh-cost quartiles.

Transaction Costs. Because the size of amutual fund trade usually exceeds that of a sep-arately managed account, mutual funds havemore opportunity to minimize the negativeimpact of transaction costs. For example, thebid–ask spread, a transaction cost, tends to vary bytrade size and bond sector, and the size of thesespreads is typically larger for small transactions.Bond funds buy and sell a large amount of bonds,with trades routinely exceeding $1 million. Thelarger transactions can command higher sellingprices and lower prices on buys. So long asbid–ask spreads are inversely related to purchase-lot size, the entity with more resources (scale) willhave an advantage. The benefits of scale are mostsignificant in non-Treasury sectors of the bondmarket, and are less so (but still important) amongTreasuries.3 On balance, fewer separate-accountmanagers boast comparable scale. However attimes, professional separate-bond-account man-agers and large institutions can trade in a size sim-ilar to that of mutual funds and therefore receivebid–ask spreads similar to those of mutual funds.

Scale can also influence the opportunitycosts incurred in different account structures. Forexample, a smaller separate account or a self-directed investor can easily reduce transactioncosts by purchasing fewer securities, but this


seemingly sensible decision produces an oppor-tunity cost: potentially lower returns and reduceddiversification. If a portfolio doesn’t have suffi-cient assets to diversify widely, the most obviousway to reduce default risk is by concentrating inbonds of the highest quality, thus sacrificing thepotentially higher returns normally availablefrom lower-quality issues. A large mutual fund,by contrast, can hedge default risk by diversify-ing widely across lower-quality bonds, minimiz-ing the effect of any one default while capturingthe returns available from lower-quality securi-ties. Table 5 outlines the option-adjusted spread(relative to Treasuries) for the Lehman U.S.Credit Index as of December 31, 2004. As thetable indicates, the difference in the option-adjusted spread between Aaa and Baa credits is82 basis points.

The basic decision comes down to this: Doesthe mutual fund expense ratio detract less fromthe portfolio’s total return than either: (1) thereturn surrendered by the credit-quality bias, ifchosen? (2) the default risk if the quality bias is notchosen? or (3) the additional transaction costs? Itwould be a rare occasion for the mutual fundexpense ratio (particularly for a lower-cost bondfund) to be larger than either of the other costs.

Table 5

Option-Adjusted Spread of Credit Qualities in LehmanU.S. Credit Index (as of December 31, 2004)

Option-Adjusted Market Value Spread (relative

Quality Percentage to Treasuries)

Aaa 10.8% 28 bp*Aa 9.6% 38 bpA 38.9% 61 bpBaa 40.7% 110 bp

* bp, basis points.Source: Lehman U.S. Credit Index as of December 31, 2004.

3 The impact of trade size on transaction costs is also noted in several recent studies,including: Edwards, Amy K., Lawrence E. Harris, and Michael S. Piwowar, CorporateBond Market Transparency and Transaction Costs, Social Science Research NetworkWorking Paper, 2004; and Chakravarty, Sugato, and Asani Sarkar, “Trading Costs inThree U.S. Bond Markets,” Journal of Fixed Income 13 (2003): 39–48.

costs. Individual bond ownership (either in a pro-fessionally managed portfolio or self-directed)mainly provides an advantage in a greater abilityto directly control various aspects of the portfolio.

As shown in Table 6, the mutual fund struc-ture primarily provides advantages regardingdiversification, more regular cash flows that pro-mote stability of portfolio characteristics, betterliquidity, and lower transaction and operating


Table 6

Summary of Structural Advantages of Taxable Bond Funds Versus Individual Bonds

Individual Bonds (Professionally Taxable Bond Funds Managed and Self-Directed)

1. Diversification Diversification Advantage

a. Among issuers, credit quality, and term structure. +

2. Cash-Flow Treatment and Portfolio Characteristics Cash-Flow/Characteristics Advantage

a. Timely initial and periodic investments. +b. Maintenance of portfolio risk characteristics

(cash flows/duration). +c. Ease of partial liquidations. +

3. Costs Cost Advantage

a. Management fees. + +(versus professionally (self-directed)

managed separate accounts)b. Transaction. +

4. Direct Control of the Portfolio Control Advantage

a. Non-inflation-adjusted liability funding. +b. Security selection (credit-quality target, etc.). +c. Principal at maturity. +

Notes: Some of the bond-fund advantages cited in the table are more pronounced for corporate bonds and mortgage-backed securities than for Treasury bonds. These advantages areaddressed in more detail in this paper.

Mutual Fund Structural AdvantagesSpecific to Corporate, Mortgage-Backed,and U.S. Treasury Bond Markets Owing to their structural advantages, mutualfunds can offer unique benefits in different sec-tors of the bond market. This section exploresadvantages of mutual funds in the corporatebond, mortgage-backed securities, and Treasurybond markets.

Diversification

Corporate Bonds. In the corporate bond market,the dynamic nature of bond credit risk makes itessential to diversify nonsystematic risk.Corporate bonds are particularly sensitive tochanges in their credit ratings. The price volatilitythat results from a change in an issue’s credit rating is typically asymmetrical: The magnitudeof the decrease in a bond’s value in anticipationof or in response to a credit downgrade is usuallymuch greater than the increase in value for anupgrade. Therefore, for investors in corporatebonds, the penalty for choosing a bond that isdowngraded is usually greater than the rewardfor choosing a bond that gets upgraded. As aresult, credit analysis is an essential part of cor-porate bond investment strategy.

While many bonds are evaluated by industrycredit-rating services (e.g., Standard & Poor’s,Moody’s Investors Service), and public access totheir current ratings is available, the market ismore concerned with what the bond’s rating willbe in the future than with what it is currently.Frequently, a majority of a bond’s relative pricedecline (when a downgrade is involved) occursprior to the actual downgrade. Credit diversifica-tion and effective credit analysis can help mini-mize a portfolio’s exposure to issues that hampera portfolio’s returns. As bonds of lower creditquality are included in the portfolio, the impor-tance of broad credit diversification and creditanalysis increases. This is a significant factor,considering that about 80% of the bonds in theLehman U.S. Credit Index were rated as eitherA or Baa (according to Moody’s), the lowesttwo levels of investment-grade bonds, as ofDecember 31, 2004.

Assuming that professionally managedmutual funds and separate accounts have equalaccess to investment and credit professionals,minimizing the impact of credit downgrades canbe achieved by diversifying by both credit qualityand individual company. The number of issuesrequired to construct a well-diversified corporatebond portfolio is debatable, but is likely to besignificant. A 2002 study by Lehman Brothersstated that an “optimally structured portfolio” of100 securities would be expected to have a track-ing error of about 30 basis points per year com-pared to the Lehman U.S. Credit Index.4 Again,this assumes an “optimally” structured portfoliowith yield-curve and sector and quality risksmatched to the index. This would not be typicalof a self-directed portfolio constructed by a non-professional; rather, such a portfolio is much morelikely to be built by larger, more sophisticated,separate-account managers or professionallymanaged mutual funds. The 100 securities wouldrepresent the minimal diversification needed.This also does not account for the fact that bondinvestors must assume that during periods ofbond market stress, volatility can be substantial.Therefore, an even larger number of securitiesmight be warranted for adequate diversification.As a result, constructing such a portfolio wouldrequire a substantial dollar commitment by theinvestor: Investing $50,000 in only 100 issueswould require a $5 million bond allocation. Incontrast to the challenge of building a portfolioof individual corporate bonds, mutual funds pro-vide readily available, diversified portfolios.

Mortgage-Backed Securities. In the mort-gage-backed market, the need for diversificationoccurs not so much at the credit level as at themortgage pool level. The credit quality of mostmortgage-backed securities is generally consid-ered second only to that of Treasuries, thus min-imizing the need for credit analysis. However,diversifying the mortgage pools in a portfolio


4 “Sufficient Diversification in Credit Portfolios,” Lehman Brothers Fixed IncomeResearch, May 2002.

can be beneficial. The underlying mortgages in apool are grouped by similar maturity dates andcoupon rates. The varying characteristics of thepools that are constructed can cause them toreact very differently to various market environ-ments, potentially causing high price volatility. Inaddition, within a specific mortgage coupon andmaturity, investors benefit by owning pools thatcontain numerous underlying loans, thus mini-mizing the negative impact of any single refi-nancing.

As with corporate bond investing, bondmutual funds provide readily available, diversi-fied portfolios. Due to the larger minimumsneeded to invest in Government NationalMortgage Association (GNMA) pools, a mutualfund of mortgage-backed securities providesinvestors with the ability to be well diversifiedand fully invested from the first dollar invested.Individual mortgage-backed portfolios, however,typically take time to build and usually do nothave a large number of securities.

U.S. Treasury Bonds. Mutual funds have lit-tle or no advantage over a Treasury bond ladderin terms of diversification, so long as the portfo-lio’s value is significant enough to permit com-plete diversification across maturities in the lad-der’s term. As direct obligations of the U.S.government, Treasuries enjoy a degree of credit-worthiness unequaled in the taxable bond world.As a result, they are generally consideredimmune from credit risk, and the cost of creditanalysis is not rewarded. Also, Treasuries issuedafter 1985 are not callable, thus simplifying thebond-selection process and resulting in more-certain principal reinvestment schedules.

Because credit and call-risk evaluation areunnecessary and the securities are liquid, pur-chasing individual Treasury bonds is the leastcomplex transaction among the various bondsectors. However, a professionally managedmutual fund or separate account has theresources (scale) and investment expertise toprovide additional analysis regarding market

conditions (that is, comparing the pricing ofnew-issue Treasuries [on-the-run] and second-ary-market-traded Treasuries [off-the-run], andTreasury valuations). For instance, the profes-sional selection of off-the-run Treasuries (highertransaction costs for smaller purchases) versusthose purchased at auction may provide enoughof a performance premium to offset a low-costmutual fund’s expense ratio. New-issue Treasurybonds usually command a price premium relativeto that of a comparable Treasury maturity inexistence in the secondary market. In addition,from a valuation standpoint, an investor musttake into account the large number of foreigninvestors in Treasury bonds who may affectsupply and demand and therefore also valua-tions. A professional manager’s responsibilitieswould include sorting through these invest-ment decisions.

The typically lower management cost of amutual fund compared with that of a profes-sionally managed separate account—albeithigher than for a self-directed bond portfolio—may be an acceptable cost for most Treasurybond investors. Offsetting that cost are conven-iences and benefits already described such asprofessional management and the reinvestmentof cash flows.

Cash-Flow Treatment and Portfolio Characteristics

Mortgage-Backed Securities. The ability to imple-ment an initial investment and then investperiodic cash flows—or liquidate an investment—in a timely manner is an especially importantbenefit in the mortgage-backed market.Individual mortgage-backed securities payincome and return a portion of principal on amonthly basis. These principal payments repre-sent the principal paid down by homeowners onthe mortgage loans held by the mortgage-backedsecurities pool. While an individual mortgage-backed security pays this principal directly toinvestors, a bond fund containing mortgage-


Sources: The Vanguard Group, Inc.; derived from data provided by Lehman Brothers.

Figure 3

1/89 1/91 1/93 1/95 1/97 1/99 1/01 1/03 5/04

10-year Treasury yield 30-year GNMA duration Lehman Aggregate Bond Index duration

Unlike the Broad Bond Market, GNMA Duration Moves Drastically With Interest Rates

0

2

4

6

8

10%

backed securities automatically uses these pay-ments to purchase more mortgage-backed pools.This automatic reinvestment of principal is oneadvantage of a mutual fund structure wheninvesting in mortgage-backed securities.

Holders of individual mortgage-backedsecurities have another concern: uncertainty as tothe duration and amount of their securities’monthly payouts. The interest income paid bymortgage-backed bonds drops as they age,because the loan’s principal value is paid downand the security’s constant coupon rate paid isbeing applied to a shrinking amount of principalin the mortgage pool. Moreover, as interest ratesrise and fall, the amount of principal repaymentfalls and rises, respectively, introducing anotherlevel of uncertainty.

As interest rates fall, homeowners accelerateor refinance their mortgages, thereby repayingmore principal on the old mortgages and causingthe pool’s monthly principal payment to rise.The opposite occurs when interest rates rise:Homeowners make their normal payments anddo not attempt to pay down principal, causingthe pool’s monthly principal payment either tofall to a more normal level or stay constant.Mutual funds are less subject to these gyrationsin income streams, because these fluctuatingprincipal payouts can be continually reinvestedin new securities with different coupon rates.The income distributions from a mortgage-backed securities mutual fund tend to correlatemore closely with interest rates than with thebehavior of a specific mortgage-backed pool.The payout of an individual pool and securitytends to be negatively correlated with interestrates.

Figure 3 illustrates how interest ratechanges can affect the duration of a single mort-gage-backed security relative to a more diversi-fied fixed income portfolio. For example, at theend of March 2004, the average duration for 30-year GNMAs was a little over 2 years; twomonths later, as the general level of interest rates

rose and fewer homeowners refinanced theirmortgage loans, the duration of 30-year GNMApools rose to almost 4 years. Although thisvolatility also exists in a mutual fund, it is mutedby the fund’s ability to diversify across a range ofmortgage pools with different maturities andcharacteristics.

A final complication caused by repaymentsof principal in an individual mortgage-backedsecurity is that as the original principal amountshrinks, the security may become difficult to sell,given the minimal demand for so-called odd-lotbonds of small principal amounts. A mortgage-backed bond fund does not face these liquidityconcerns, as the fund would simply allow thesebonds to eventually liquidate themselves throughmonthly principal payouts. Any shareholderredemptions could be easily financed from thefund’s ongoing cash flows.


Primary Advantage of Owning Individual Bonds

Direct Control of Portfolio

Although, as described here, the mutual fundstructure boasts significant investment meritsover self-directed individual bond portfolios andprofessionally managed separate accounts, thesealternative structures offer one notable advan-tage over mutual funds: the ability to controlsecurity-specific portfolio decisions. The value ofthis benefit is most apparent in situations wherean investor wishes to match the maturity andface value of a bond with a known nominal(before inflation) future liability. Bond mutualfunds do not have a maturity date, so the value ofthe fund at any point in the future is uncertain.When an investor has a predetermined futurespending need, however—particularly if it is anear-term need—an individual bond that ma-tures when the money is required may be prefer-able to a bond mutual fund. As stated in theintroduction to this paper, this control becomesmuch more limited for bonds with options, suchas corporate and mortgage-backed securities.

This cash-flow matching strategy (a form ofasset-liability matching) involves purchasingindividual bonds that carry coupon paymentsand par values at maturity precisely matching thevalue of liabilities coming due. Cash-flowmatching is the most conservative and passiveasset-liability-matching strategy. Once cashflows are matched, the asset portfolio need onlybe adjusted for changing liabilities. Cash-flowmatching can be a very inflexible process, how-ever, and is often costly to implement, because itrequires that expected payment streams exactlymatch the cash flows of fixed income invest-ments. One method of cash-flow matching is tobuild an asset portfolio of zero-coupon bondsthat match liability maturities. Specifically,Treasury STRIPS, because of their lack of

default risk, may be the most straightforwardway to match liability cash flows.5

One important limitation of cash-flowmatching strategies is that they typically can’taccount for the effect of inflation on the liabilityamount. For example, if a general liability is$30,000 today, what should be budgeted for thefuture value of that $30,000 payment 15 yearsfrom now? Matching a $30,000 liability with a$30,000 bond does not take into considerationthe fact that, owing to inflation, the liability maybe higher when it becomes payable. Future infla-tion is difficult to estimate, but to forecast theidiosyncratic inflation rate associated with a par-ticular liability (medical costs, construction) iseven more problematic. Therefore, a passiveapproach (such as the purchase of a single bondor a bond ladder) usually results in the “real”(inflation-adjusted) liability being either over-funded or underfunded, depending on the ac-tual inflation rate experienced over the fundinghorizon.

Matching more-certain nominal liabilitieswith known future dates can be done rather sim-ply with little ongoing intervention. However,when liabilities are more volatile, less certain(due to inflation), and require matching on aninfinite basis, an asset-liability matching strategynearly always demands an active bond-manage-ment strategy, which can be extremely costly andcomplex. As a result, using individual bonds toaccommodate future “real” liabilities is moreviable for the short-term, rather than for thelong-term. Similarly, short-duration mutualfunds—such as money market or short-term tax-able bond funds—that have historically experi-enced little fluctuation in principal (net asset


5 STRIPS, for Separate Trading of Registered Interest and Principal of Securities, arebonds—usually issued by the U.S. Treasury—whose two components, interest andprincipal, are separated and sold individually as zero-coupon bonds.

value) might be used to meet these near-termliabilities.

Finally, an individual bond portfolio can betailored for very specific objectives in which aninvestor has complete control over the selectionof specific bonds or types of bonds. For instance,a specific credit-quality target (such as an all-Aaaportfolio), specific characteristics (no deriva-tives), or specific call-protection targets are someof the possibilities.

Although a cash-flow-matching strategy isa benefit in limited situations, it’s important toreiterate that there is no economic value toreceiving principal back at maturity if the princi-pal is used not to fund a cash flow, but simply forreinvestment. As securities in a laddered portfo-lio mature, they are reinvested, just as they are ina mutual fund, producing the same return ineach portfolio. Naturally, it would be very diffi-

cult for a separately managed account to achievecost parity, cash-flow parity, and diversificationsimilar to those of a mutual fund. In essence,when the principal paid at maturity or redemp-tion is reinvested, rather than spent, a ladderedportfolio functions similarly to a mutual fund,but with greater costs and less diversification.

The certain repayment of principal shouldnot be a primary issue in a long-term investmentstrategy. Inflation—and the way it will affect thepurchasing power of that principal by the timethe bond matures—is the more important issue.Two factors affect whether or not the principal’spurchasing power is maintained: (1) whether theinvestor spends the interest payments, and (2)whether the forecast annual inflation rate is lessthan or equal to the actual annual inflation ratefor the period. Figure 4 illustrates this point witha hypothetical example.


Source: Vanguard Investment Counseling & Research.

$120,000

100,000

80,000

60,000

40,000

20,000

0

Figure 4

Hypothetical Example of a Bond’s Cumulative Cash Flow (6% coupon, 15 years to maturity, 3% expected inflation, 3% real interest rate)

Inflation payment Real interest-rate paymentPrincipal repaymentAnnual need (3% inflation rate first five years; 4% thereafter)Annual need (3% inflation rate)

Cum

ulat

ive

Cash

Flo

w

1 32 54 8 12 13111096 7 14 15

$85,800

$77,898

Year

This hypothetical illustration does not represent the return on any particular investment.

At the time of initial purchase, a bond’syield includes an assumption about the futureinflation rate (including a risk premium tied tothe level of uncertainty regarding future inflation).This portion of the yield (the “inflation pay-ment”) is compensation to offset the expectederosion of the purchasing power. Figure 4depicts the cumulative cash flows of a bond, withthe coupon divided into its inflation paymentand real interest-rate payment, and the principalrepaid at maturity. The bottom line of the figureillustrates the inflation-adjusted purchasingpower of the principal. This hypothetical exam-ple starts with an inflation rate of 3%. If that ratecontinued unchanged, the goods and servicesthat $50,000 buys today would cost $77,898 in15 years.

Figure 4 also demonstrates that if interestpayments are being spent, the $50,000 principalpaid at maturity is far less than the $77,898needed to keep pace with inflation. In essence,15 years from now, $50,000 would purchase 36%less than it does today. To maintain purchasingpower, therefore, only a portion of the interestpayments should be spent (the portion repre-senting their real rate), with the balance beingreinvested.

What happens if the inflation rate is differ-ent from the initial 3%? The top line in Figure 4illustrates the inflation-adjusted principal bal-ance if inflation were 3% for the first five yearsand increased to 4% for the remaining term.Instead of needing $77,898 to maintain theprincipal’s purchasing power, the investor wouldneed $85,800 at maturity. Since the inflation-payment portion of the yield was locked in at 3%when the bond was purchased, the bond’s pay-ments are insufficient to offset the effects of thehigher-than-expected inflation. As a result, theinvestor’s real return is diminished. In summary,if there is no targeted spending need, theinvestor should focus on maintaining the portfo-lio’s purchasing power over time.

ConclusionFor the reasons described in this paper, the vastmajority of investors in taxable bond portfoliosare best served by low-cost mutual funds. Onlythose investors with the resources to achievescale comparable to that of a mutual fund shouldconsider putting certain control features ahead ofa mutual fund’s benefits. Mutual funds generallyprovide better diversification, more efficientmanagement of cash flows and portfolio charac-teristics, better liquidity, and lower costs.

Although directly held bonds can providecertain advantages over bond mutual funds—primarily related to control over security-specificdecisions—such control comes at a cost. To con-struct an individual bond portfolio, an investormust assign a very high value to the controlaspect to justify the higher costs and additionalrisks involved.


®

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Investment Counseling & ResearchPost Office Box 2600Valley Forge, PA 19482-2600

[email protected]

The Vanguard Group, Vanguard, and the ship logo are trademarks of The VanguardGroup, Inc. All other marks are the exclusiveproperty of their respective owners.

I N V E S T M E N T C O U N S E L I N G & R E S E A R C H

Catherine D. Gordon/Principal/Department Head

Francis M. Kinniry Jr., CFA/PrincipalDaniel W. Wallick/PrincipalNelson W. Wicas, Ph.D./Principal

Frank J. Ambrosio, CFAJohn Ameriks, Ph.D.Donald G. BennyhoffJoseph H. Davis, Ph.D.Scott J. Donaldson, CFA, CFPColleen M. Jaconetti, CFP, CPAChristopher B. PhilipsKimberly A. StocktonYesim Tokat, Ph.D.David J. Walker, CFA

© 2005 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor. ICRTBF 032005

For more information about Vanguard funds, visit www.vanguard.com, or call 800-523-1036, to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

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