By J.R. Robinson, Financial Planner (April 2025)
Several years ago, I wrote an article for the FPH newsletter titled, “Friends Don’t Let Friends Buy Bond Funds.” That refrain has become an enduring mantra in my financial planning practice, and it rings just as true today. In a rising interest rate environment, the choice between individual bonds and bond mutual funds becomes crucial for investors seeking stability and predictable returns. The advice I continue to give about avoiding bond mutual funds and ETFs in favor of individual fixed income securities, such as Treasuries and certificates of deposit, reflects the mounting evidence and academic research highlighting the pitfalls of bond funds when rates climb, and the comparative advantages of owning individual bonds.
The Problem with Bond Mutual Funds in a Rising Rate Environment
When interest rates rise, bond prices fall. Bond mutual funds, which hold portfolios of bonds with varying maturities and durations, are especially vulnerable to this dynamic:
- No Maturity Date: Unlike individual bonds, bond funds do not mature. This means investors cannot simply wait for their principal to be returned at par; instead, the fund’s net asset value (NAV) can continue to decline as rates rise, with no guarantee of recovery[1][2].
- Interest Rate Sensitivity: Academic research shows that investment-grade bond funds, in particular, suffer significant capital losses during periods of monetary tightening. As interest rates increase, long-term bond funds experience outflows and price declines, while short-term funds become more attractive[3].
- Herd Effect and Forced Selling: Bond fund investors are exposed to the “herd effect”-when many investors redeem shares during market stress, fund managers may be forced to sell bonds at unfavorable prices, crystallizing losses for all shareholders[1].
- Lack of Control: Investors in bond funds have little control over the timing of bond sales, interest rate risk, or tax consequences, as these are determined by the fund manager and the behavior of other investors[1][4].
Why Individual Bonds Offer an Edge
Owning individual bonds provides several key advantages, especially when rates are rising:
- Return of Principal at Maturity: If held to maturity (and absent default), individual bonds pay back their face value, allowing investors to ignore interim price swings and avoid permanent loss of capital[1][2].
- Control Over Timing: Investors can plan their income stream and manage tax consequences, choosing when to buy, sell, or hold bonds[1][4].
- Immunity to Fund Flows: Individual bondholders are not affected by the actions of other investors, avoiding forced sales and the herd effect that can plague bond funds[1].
Academic Support for Individual Bonds
A 2023 study by Huang et al. found that during periods of rising interest rates, long-term investment-grade bond funds suffered more capital losses than short-term funds, and that investors moved away from these funds to avoid further losses[3]. The research underscores that bond funds, especially those with longer durations, are more exposed to interest rate risk than portfolios of individual bonds held to maturity.
RBC Wealth Management’s analysis further supports this view, emphasizing that individual bond investors can “ignore the market volatility and potential price declines, confident that their full principal investment will be returned at maturity, absent a default.” They highlight that the ability to control transactions and tax outcomes is a defining reason why individual bonds are preferable to bond mutual funds for many buy-and-hold investors[1].
Conclusion
In a rising rate environment, the drawbacks of bond mutual funds-NAV volatility, lack of maturity, forced sales, and loss of control-become painfully clear. Academic research and wealth management experts increasingly favor individual bonds for their predictability, control, and resilience against interest rate shocks. In the consumer investment space (as opposed to the institutional space), investors expect the “safe” portion of their portfolios to be just that. When we have a year such as 2022, when interest rates on bonds rose sharply, many retirees and investors approaching retirement saw the values of their so-called “conservative” bond funds (including target retirement date funds) fall by 15%-20% or more. Does that seem like “safe” to you?
Of course, part of the reason why bond funds have been and continue to be pitched as conservative is attributable to the fact that interest rates were in long term decline for most of the last 40+ years. That decline ended when rates could literally not fall any lower in 2021. Since then, rates have been creeping back toward more historically normal levels. With less interest rate predictability, consumers may do well to climb onto the band wagon, and take up my bond fund avoidance mantra too.
John H. Robinson is the owner/founder of Financial Planning Hawaii and Fee-Only Planning Hawaii. He is also a co-founder of fintech software maker Nest Egg Guru and the new personal finance website NestEggPF.com.
References:[1] RBC Wealth Management, “Individual bonds versus bond mutual funds”[3] Huang et al., “Investors’ Interest Rate Risk Exposure: Evidence from Corporate Bond Mutual Fund Flows,” 2023[2] State Street Global Advisors, “Individual Bonds vs. Bond Funds: A Comparison”
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- https://rbcus.prod.digitalagent.app/delegate/services/file/3486369/content
- https://www.ssga.com/us/en/intermediary/resources/education/individual-bonds-vs-bond-funds-a-comparison
- https://acfr.aut.ac.nz/__data/assets/pdf_file/0009/812709/interest_rate_risk4-2.pdf
- https://www.fidelity.com/learning-center/investment-products/mutual-funds/bond-vs-bond-funds
