TAILIEUCHUNG - Taxable Bond Investing: Bond Funds or Individual Bonds?

For most taxable bond investors, bond mutual funds have a number of advantages over individual bond portfolios in terms of diversification, cash-flow treatment and portfolio characteristics, liquidity, and costs. Individual bonds do provide certain benefits compared with bond mutual funds, and these advantages revolve primarily around a preference for control over security-specific decisions in the portfolio. The cost of this advantage can be thought of as a “control premium” that is reflected in generally higher (or additional) transaction costs, lower liquidity, more limited return opportunities, and higher bond portfolio risk. The cost of the control premium is more pronounced for buyers of corporate bonds and mortgage-backed securities than for buyers. | Taxable Bond Investing Bond Funds or Individual Bonds Vanguard Investment Counseling Research Vanguard Executive summary For most taxable bond investors bond mutual funds have a number of advantages over individual bond portfolios in terms of diversification cash-flow treatment and portfolio characteristics liquidity and costs. Individual bonds do provide certain benefits compared with bond mutual funds and these advantages revolve primarily around a preference for control over security-specific decisions in the portfolio. The cost of this advantage can be thought of as a control premium that is reflected in generally higher or additional transaction costs lower liquidity more limited return opportunities and higher bond portfolio risk. The cost of the control premium is more pronounced for buyers of corporate bonds and mortgage-backed securities than for buyers of . Treasuries. Author Scott J. Donaldson CFA CFP Connect with Vanguard 800-997-2798 Introduction This paper primarily examines the advantages of bond mutual funds over portfolios of directly held bonds for both institutional and individual investors. First we review the structural advantages of bond mutual funds which compared with separately managed and laddered1 portfolios of individual bonds generally provide greater diversification more regular cash flows that promote stability of portfolio characteristics better liquidity and lower transaction and operating costs. Second we explore the unique advantages of a mutual fund portfolio in three discrete sectors of the taxable fixed income market corporate bonds mortgage-backed securities and . Treasury bonds. The paper s final section describes the limited situations in which a portfolio of directly held bonds can provide advantages over a mutual fund. We characterize most of these advantages as control benefits and refer to their potentially higher cost as the control premium. This control becomes more limited when considering

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