Bonds vs. Bond ETFs With Nicole Sennett: Which One Should You Choose As Interest Rates Decline?

Federal Reserve policymakers recently announced a 50-basis-point interest rate cut during their September 2024 meeting. They also said additional rate cuts may be in store for 2024, 2025, and 2026.

As interest rates decline, investors face a critical decision: Should I invest in individual bonds or opt for bond exchange-traded funds (ETFs)? It is important to understand the nuances of these two investment vehicles before finalizing a strategy.

Below, we’ll explain the differences between individual bonds and bond ETFs. We’ll then review their pros and cons and highlight how they typically respond to a declining interest rate environment.

Individual Bonds vs. Bond EFTs: What’s the Difference?

Bonds and bond EFTs may sound similar as two forms of fixed-income investments. However, they differ in some notable ways.

Here’s a brief overview of these two investment vehicles:

• Individual bonds – Governments and corporations issue bonds to raise capital. You’re essentially lending money to the issuer when you purchase a bond. In exchange, you receive periodic interest payments, known as the “coupon,” typically paid twice yearly. Once your bond matures, you also get back its principal, assuming its issuer doesn’t default on its debt. Bonds are a relatively safe investment, making them an attractive option for conservative investors prioritizing predictable income and capital preservation.
• Bond EFTs – Bond EFTs are investment funds that hold a varied portfolio of bonds. Their structure provides more liquidity and diversification than individual bonds. For example, you can buy and sell shares of bond EFTs throughout the trading day at market prices. Since bond EFTs bundle tens to hundreds of bonds together and often feature a mix of corporate, municipal, and government bonds, they reduce the risks associated with any single issuer defaulting. This diversification can provide peace of mind to risk-averse investors.

How Do Interest Rates Affect the Bond Market?

Many factors influence bonds and bond EFTs, including inflation, credit risk, currency risk, market sentiment, the bond yield curve, and supply and demand. Interest rates are another key component.

Interest rates are crucial in the bond market, influencing bond prices and yields. Here’s how:

• Prices – A bond’s price is the amount you pay to purchase it. This price reflects the present value of the bond’s future cash flows, including its principal amount and periodic interest payments. Bond prices and interest rates are inversely related. As a result, bond prices typically rise as interest rates fall. That’s because older bonds with elevated interest rates offer higher yields than newer bonds issued at lower rates.
• Yields – Bond yield refers to the return you can expect to earn from a bond. It’s expressed as a percentage and can be calculated in two ways:
  • Current yield is calculated by taking the annual coupon payment and dividing it by the bond’s current market price.
  • Yield to maturity (YTM) represents the total return an investor can expect if the bond is held until maturity. It factors in the coupon payments and any capital gains or losses that arise from purchasing the bond at a price different from its face value.

Bond yields are inversely related to bond prices. As bond prices rise in response to declining interest rates, yields typically decrease.

Learn More: The Bond Curve is No Longer Inverted—Is Your Bond Ladder Ready?

Pros and Cons of Individual Bonds in a Declining Rate Environment

Now that you understand the fundamental differences between individual bonds and bond EFTs, let’s examine their pros and cons.

Pros of Individual Bonds

Investing in individual bonds offers the following advantages:

• Predictable returns – Individual bonds provide fixed interest payments typically paid semi-annually. As a result, you know exactly how much money you’ll receive from the start. This predictable income stream can be attractive during periods of declining interest rates, especially for conservative investors or those nearing retirement, since it can enhance budgeting and financial planning.
• Capital preservation – Another key advantage of individual bonds is that you can insulate yourself from market price fluctuations by holding them to maturity. As long as your issuer doesn’t default, you can expect to receive the full face value of your bond once it matures, regardless of changing market conditions. This “buy-and-hold” strategy aligns with Mark Twain’s popular investing sentiment, which states: “The return of my money is more important than the return on my money.”
• Control and customization – Individual bonds allow you to hand-pick issuers and maturity dates that align with your investment goals and cash flow requirements. For example, if you need to pay for your child’s college tuition in five years, you can select bonds that will mature at the ideal time.

Cons of Individual Bonds

While individual bonds have many benefits, they also have some downsides to consider:

• Interest rate risk – Holding individual bonds to maturity can mitigate their interest rate risk. However, you never know when financial circumstances require liquidating your bond holdings. Selling individual bonds prematurely in unfavorable interest rate conditions can result in a loss.
• Limited diversification – With individual bonds, achieving the same level of diversification as bond ETFs can be quite challenging. As a result, your portfolio may be more concentrated in a specific set of issuers or sectors. If any of these issuers default, you could face significant risk exposure.
• Liquidity issues – Individual bonds are less liquid than bond ETFs, making buying or selling them quickly at favorable prices harder. This lack of liquidity can result in wider bid-ask spreads and potentially higher transaction costs, especially for less commonly traded bonds.

Pros and Cons of Bond ETFs in a Declining Rate Environment

Now that we’ve covered individual bonds, let’s explore the benefits and drawbacks of bond EFTs.

Pros of Bond EFTs

The primary perks of investing in bond EFTs include:

• Diversification – Bond ETFs stand out for their built-in diversification. A bond ETF can hold hundreds to thousands of bonds, significantly reducing the risk associated with any one issuer defaulting. This diversification is particularly beneficial in declining interest rate environments where some bonds may underperform while others excel.
• Liquidity – Bond ETFs are traded on stock exchanges, so you can buy and sell shares throughout the trading day. This enables you to respond quickly to market changes and optimize your portfolio during volatile economic conditions. Bond EFTs’ liquidity also makes it easy to enter and exit positions without significantly impacting their market prices.
• Ease of management – Bond ETFs are professionally managed, so you don’t need to worry about monitoring and managing your portfolio yourself. Instead, you can leave the professionals the credit risk assessment and portfolio rebalancing. This perk may be particularly attractive in a declining rate environment as shifts in interest rates influence bond performance. Investors who don’t have the time, interest, or expertise to manage individual bond investments often prefer bond EFTs for this reason.
• Cost efficiency – Individual bonds often require a higher initial investment and may incur brokerage fees each time a bond is purchased. In contrast, bond ETFs typically have lower expense ratios. Thus, the overall costs associated with bond ETFs, including their management fees, are often lower than the cumulative costs of purchasing and maintaining a portfolio of individual bonds.

Cons of Bond EFTs

With bond EFTs’ benefits in mind, let’s quickly examine their potential drawbacks:

• Price volatility – Bond ETFs offer greater liquidity than individual bonds but can experience price fluctuations throughout the trading day. During particularly turbulent periods, their market prices may diverge markedly from the underlying value of the bonds they hold, spurring skittish investors to sell off their shares at a loss. These price swings can be unsettling for investors who are used to the stability of individual bonds.
• No guarantees – Unlike individual bonds held to maturity, bond ETFs don’t guarantee the return on your principal investment. This lack of capital protection can make bond ETFs less appealing for investors who value the security of knowing they’ll receive their initial investment back.

Individual Bonds vs. Bond EFTs: Which One Should You Choose?

While individual bonds and bond EFTs present compelling pros and cons during declining interest rate environments, the right choice ultimately depends on your financial goals, risk tolerance, and investment strategy.

Here’s a quick guide to help you decide:

• Choose individual bonds if:
  • You prioritize capital preservation and plan to hold your bond investments to maturity.
  • You prefer the predictability of fixed-interest payments and want to avoid market volatility.
  • You want more control over specific bond selections, such as credit quality and maturity dates.
• Choose bond ETFs if:
  • You value seamless diversification.
  • You desire greater liquidity and the ability to trade throughout the day.
  • You prefer the convenience of professional management and want to benefit from economies of scale in bond investing.
• Choose a hybrid strategy if:
  • You want to combine individual bonds’ stability with ETFs’ diversification.
  • You’re interested in using bond ETFs for liquidity while holding certain individual bonds for long-term security.
  • You want to manage risk by having both structured income and market-responsive investments in your portfolio.

Customize Your Bond Investment Strategy With Nicole Sennett

In summary, bonds and bond EFTs are two fixed-income investments that have a lot to offer. If you want professional support as you hone your bond investment strategy, Nicole Sennett can help. Nicole is an independent financial advisor specializing in retirement planning and wealth management.

Since 2005, Nicole has crafted custom investment strategies for her retiree and pre-retiree clients, collaborating with their CPAs and attorneys at every stage. Thanks to her strategic partnership with Alden Investment Group, she leverages institutional managers to enhance her investment performance and portfolio diversification.

Ready to revamp your bond strategy? Schedule your consultation with Nicole Sennett today.

Sources:

Federal Reserve. Federal Reserve issues FOMC statement.
https://www.federalreserve.gov/newsevents/pressreleases/monetary20240918a.htm

Forbes. Investment Advice You Can Actually Use.
https://www.forbes.com/sites/timmaurer/2012/05/11/investment-advice-you-can-actually-use/