Fact-Checking Suze Orman’s Take On Bonds

Financial guru Suze Orman says to say no to bond funds and yes to individual bonds. Her rationale is that if interest rates climb in future years—as is likely given today’s very low levels—the prices of existing bonds with lower rates will fall.

The impact may be felt more keenly by holders of bond mutual funds and exchange-traded funds than by investors who have bought individual bonds. Owners of individual bonds can wait and collect their full principal upon maturity.

The thrust of the argument is that building a laddered portfolio of individual bonds eliminates the interest-rate risk from potential rising rates. This argument, appealing as it might be, is simply wrong, and here’s why.

Debunking The Myth

Let’s say an investor buys a one-year corporate bond at a $1,000 face value that pays a 3 percent interest rate at the end of the year. She expects to get back $1,030 in a year. The bond is worth $1,000 today because the market pegs the 3 percent rate as a fair rate for this type of bond. The math behind it goes like this: $1,030/1.03 (one plus the interest rate) = $1,000.

In this hypothetical example, immediately after she buys the bond, news comes out of increasing inflation expectations, and suddenly investors want a 4 percent yield on this type of bond. Looking up the value of his bond, she finds it is now worth only $990.38 ($1,030/1.04), declining by $9.62. Still, this investor may take comfort in not having lost a dime, as she is still going to get the $1,030 back, which is exactly what she bargained for.

Unfortunately, she is only going to receive $30 interest when the market now demands $40 interest for this type of bond. This translates to receiving $10 less in one year, based on the current 4 percent return expectation. The investor is immediately out $10.00/1.04, which is exactly equal to be the $9.62 decline in value of her bond. Not merely a coincidence.

Always The Same

The math always works out the same irrespective of the interest rate or the maturity of the bond. That is to say, the change in the current value of the bond will be equal to the present value of the cash to be received from the interest payments and the return of principal.

Simply put, if interest rates increase, the value of the fixed interest payments and the return of principal declines. Holding the bond until maturity does nothing to protect the investor from increasing interest rates. The investor just receives less money than the current market would dictate.

If the above hasn’t convinced you, consider that good bond funds, like the Shares Core U.S. Aggregate Bond ETF (AGG | A-98) and the $27 billion Vanguard Total Bond Market ETF (BND | A-94) are laddered bond portfolios. Thus, it’s an absurd argument that a portfolio of laddered bonds has less interest-rate risk than a fund of laddered bonds with the same duration.

3 Ways Bond Funds Are Superior To Individual Bonds

Not only is Suze wrong on bond funds having more interest-rate risk, she fails to mention where bond funds are superior:

1. Bond funds trade at net asset value with no spreads to buy and sell. Individual bonds can easily have bid-ask spreads in the one to three percent rate, or more than a year’s interest.
2. Bond funds can own thousands of bonds providing more diversification.
3. Bond funds can reinvest your interest payments vs. the many investors who leave interest from individual bonds earning 0.01 percent, since they likely won’t have enough money to buy another bond for quite some time.

While I disagree wholeheartedly with Suze on this particular issue, she may indirectly have a point. Because it’s easy to give yourself the illusion that individual bonds have no interest-rate risk, it’s easier to avoid the herd mentality of selling when bonds decline. But rational investors should be rebalancing, and here bond funds also have the advantage, since buying funds have far lower costs.

At the time of writing, the author owned shares of VBTLX, a mutual fund version of Vanguard's aggregate bond ETF, BND. Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning Magazine.