Do bond funds have an inherent advantage over individual bonds within a portfolio?

Question

Background: I am constructing a simple ETF portfolio consisting of 70% stocks and 30% bonds. Every three months, I will add money into the portfolio, and rebalance the portfolio to restore its 70/30 allocation. I am aiming for something similar to the Bogleheads' two-fund portfolio, with 70% invested in a global stock ETF and 30% invested in bonds.

Suppose I have access to the following instruments to fill the bond component of the portfolio:

1. An investment grade bond ETF.
2. A special risk-free savings bond with slightly higher yield than the bond ETF above (for the same duration as the bond ETF). Assume that this bond is truly risk-free, and has a low minimum investment requirement.

My question is about the bond ETF vs the individual bond. From my understanding, there are advantages of having a bond ETF in a portfolio:

• The periodic 70%/30% rebalancing automatically ensures that stocks tend to be sold when stock prices goes up, and bought when stock prices go down.
• The bond component reduces the volatility of the portfolio, because bonds are typically less volatile than stocks.
• As a result, most of the stock market returns are captured with less volatility.

Do these advantages also apply to the individual bond? Due to the risk-free nature of the individual bond and its higher yield, I am considering investing the entire bond component in the individual bond instead of the bond ETF. Besides the liquidity of ETFs, are there reasons for choosing the bond ETF over the risk-free bond in question?

In other words, do bond funds have an inherent advantage over individual bonds within a periodically rebalanced portfolio that has a fixed bond allocation?

EDIT:

What I would really like to know is: Do bond funds have an inherent advantage over individual bonds such that I should overlook the lower risk and higher yield of the individual bond in question, and instead invest my money in a bond ETF?

Answer 1

Your main advantage is diversification. As an individual investor it can be hard to just buy individual bonds. The bond market is targeted towards institutional investors with larger portfolios. Many have a minimum granularity that is impractical for the sums of the average Joe. And even if the bare minimum for a bond is within your means you might have trouble to find someone trading the bare minimum while for stocks and funds there is the established structure of market makers that will trade arbitrarily small amounts.
A bond fund allows basically arbitrary contributions to a basket of bonds. It allows to rebalance by increments of let's say 50€/$/whatever which is pretty manageable and rebalanceable. It is also able to diversify across multiple durations or debtors.

Another advantage for foreign bonds can be currency hedging. This is again a market that is targeted towards the big guys and hard to pull off for a small investor who wants to have 1000€ hedged against USD. Given the currently low interest rates, hedging for foreign currencies is probably a good idea in bonds.

However, bond funds also come with a disadvantage. First, they cost some fees. Given the advantages that is OK but it will put them slightly behind owning bonds directly. The bigger issue with bond funds is that they typically will not buy bonds on the initial offering and hold them to maturity. Bond funds trade bonds and therefore expose the investor to interest rate risk. When interest rates rise, the value of your bond fund will decrease and you may take a nominal loss. Holding bonds yourself until maturity would prevent this

Answer 2

I am considering investing the entire bond component in the individual bond

A special risk-free savings bond with slightly higher yield than the bond ETF above (for the same duration as the bond ETF).

A bond ETF typically has the following characteristics:

• Contains bonds from more than 1 issuer for diversification (except treasury).
• Sells holdings and buys newly issued bonds to maintain the Duration because as time passes, the Duration of the portfolio reduces. A certain Duration is needed to take advantage of the negative correlation between bond and stock.
• purchasable in small amounts e.g. USD$100.

You can definitely achieve the same effect without holding a bond ETF by:

1. Buying individual bonds at ~$100,000 each to achieve sufficient diversification.
2. Sell and buy bonds every month.
3. Having $2,000,000 for #1.

Your question is almost the same as asking "Can I directly buy each constituent of S&P 500 instead of buying SPY."

Another thing is that the two-fund portfolio (or any other similar portfolio) is based on Modern Portfolio Theory, i.e. "buy the market" because it is unlikely that the entire market (of a country or of the world) fails in the long run. A "savings bond" does not represent the diversification of a bond fund.

Answer 3

(This answer is US-centric. I don't know about other countries' bond markets.)

In other words, do bond funds have an inherent advantage over individual bonds within a periodically rebalanced portfolio that has a fixed bond allocation?

Yes, I think so.

I've looked at this problem too, and the problems (at least for someone at my scale) with buying individual bonds are:

1. What to do with the interest?
2. You (effectively) can't rebalance.

Both issues are tied to the fact that,while bonds nominally cost only $100, you can't buy just one. They're sold in units of 100 or even 200. Thus, 30% of your investment pool might not be (even close to being) equally divisible by $10000.