Individual bonds or bond index funds?

which index fund - there are all different types for fixed income - is it VBMFX ?

I would stick with index funds. It is hard to match their costs at a small scale.

i

The big advantage of an individual bond over an index fund is that with the individual bond, assuming the issuer does not default, you will always recover you principle and earn the specified interest rate if you hold the bond to maturity.

If you buy a fund there is no maturity so if you buy when rates are low and rates go up the price of the fund's shares will drop. If the fund has a duration of five years the price of the fund shares will drop 5% for each 1% increase in interest rates. There is no point in time when you are guaranteed to get your principle back.

IMHO the ratings are not worth much. Remember that most of the CMOs and CDOs that became worthless during the recent meltdown were rated AAA by the same rating agencies that rate bonds. If you do plan to buy individual bonds you need to perform the same financial analysis on each company you would perform if you were buying the companie's common stock.

The costs of buying individual bonds can be substantial unless you are very careful. This is particularly true of municiple bonds which are frequently very illiquid. Most muni issues don't trade once a year so if you have to sell you may take a substantial loss.

I like Fidelity's 5 year ladder program:

Frank

you mean a specific ladder of investments, or the overall concept as driven by this tool -

When and if interest rate goes up, bond funds are going to go down. Individual bonds are going to keep paying the same interest if you don't sell them. Not true of bond funds.

(Some pundits are predicting that eventually interest rate is going to go up, thus bond funds values are going down.)

Homer, it's pretty standard to see the bond vs. bond fund arguments (offered above) that hinge on potential principle loss. And (for some reason) the advantage typically goes to bonds over bond funds. I'll offer a different point of view:

Bond proponents typically dote on the fact that you can hold a bond to maturity and evenutally get your principle back. But I never hear anyone note that we're not talking about bonds with one year maturities here. Bond rates are typically (and currently) lower for shorter term bonds. The only way to get the highest interest rates is to buy bonds with long-term maturities (like 20+ years). Who can wait that long if they need the cash? What are the chances you're going to be near maturity when the liquidity need arises? Who can predict their needs that far into the future? And, of course, if you have to sell prior to maturity, you're no better off than had you bought bond funds (probably worse off, depending upon a specific set of facts).

Moreover, when looking at 20+ year time periods, there's a good chance that interest rates are going to both rise and fall. With a bond (bought today at some paltry rate) the market price is almost always going to be lower than the maturity amount (rates can't practically get any lower than they are now). But a bond fund continually reinvests into the market. That means that not only will your income climb as rates increase, but if rates begin to fall (again) you can sell AT A GAIN! So a bond fund provides the OPPORTUNITY to get out early and actually make money. Given todays incredibly low interest rates, I can nearly assure you that won't happen with an individual bond. If current rates were higher, bonds would also have this opportunity.

Nevermind the inherently greater risk associated with buying individual bonds. It takes a rather large sum of money to buy enough bonds to both diversify your holdings and overcome the fixed cost of buying those bonds. You probably need $500k or more.

Once ALL things are considered, I see more people go into bond funds than actual bonds for all of the reasons stated above. The trick is to simply make sure that you have other sources of liquidity (hence eliminating the need to sell). If you have absolutely no other sources of cash, then either your financial plan is setup incorrectly or you're trying to put too much into fixed income.

Owning a fund means owning many small pieces of individual bonds, it is the same thing, the difference is mental accounting.

i

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I like the overall concept. The income can be scheduled based on maturities. The return does not depend on market conditions after the bonds are purchased. It is possible to trade off risk and return. Of course default is a risk.

Frank

Investing in a bond fund provides you a share of a diversified portfolio of bonds allows easy investment and sale of the investment at market prices.