Bonds or Bond Funds for Retirement Income?

June 9, 2010

Rob Williams
Director of Income Planning, Schwab Center for Financial Research

Depending on your situation and needs, it's possible to generate retirement income in a number of ways. Two common choices are bonds and bond mutual funds.

The choice between bonds and bond funds doesn't have to be an all-or-nothing decision, either. You may want a combination of both to meet your retirement needs.

Here, we'll look at several different scenarios to help determine when bonds or bond funds might be more appropriate for retirement-income generation.

Scenario: A retiree in need of a specific level of income
Solution: Individual bonds

Individual bonds can offer regular, fixed payments and targeted maturity values, and building a bond ladder can help create an ongoing income stream. Even if the market value of a given bond fluctuates during its term (depending on changes in interest rates, overall credit quality of the issuer, etc.), it shouldn’t affect your retirement income unless you need to sell prior to maturity, or the bond experiences credit quality issues.

Conversely, bond funds' income payments can vary over time, so retirees more focused on generating a specific level of income might not be as comfortable with the variability of payments from bond funds.

Scenario: A retiree doesn’t want to incur certain capital gains
Solution: Individual bonds

When investing in bond funds, investors pay tax on capital gains realized from a fund's trading or from the redemption of shares. For some investors, a portion of the fund's income could be subject to the alternative minimum tax, as well. With individual bonds, on the other hand, investors are only required to pay capital gains taxes if the bond is sold for a profit prior to the maturity date, or if the bond was purchased at a discount.

Scenario: A retiree seeks full redemption value at maturity
Solution: Individual bonds

Bond funds have no identifiable maturity date because bonds are constantly being bought and sold, meaning there's no way to predict the fund value at any given time. Conversely, individual bonds not only have a set maturity date, but will also repay your principal at maturity (the exception being default). If you're a buy-and-hold investor, the pledge of repayment of a specific principal amount for an individual bond held to maturity makes fluctuation in market price in the interim less relevant, unless you need to sell.

Scenario: A retiree who seeks portfolio protection through diversification
Solution: Bond funds

When investing in individual bonds, we recommend you hold bonds from at least 10 different issuers in order to achieve proper diversification, unless you're only choosing US Treasuries or other bonds with very low credit risk. Bond funds, on the other hand, are very unlikely to hold bonds from 10 or fewer issuers, because of diversification rules. In fact, corporate and municipal bond funds rarely own fewer than 30 issuers, and often own hundreds.

In addition, when investing in individual bonds, you'll generally need a minimum investment amount of $10,000 for a corporate bond portfolio ($1,000 per bond) and $50,000 for an uninsured municipal bond portfolio ($5,000 per bond) to achieve proper diversification. Because bond funds typically hold hundreds of bonds in a single fund, one of their biggest advantages is diversification, regardless of the amount invested.

Many investors who seek to boost their incomes with other, more aggressive types of bond investments (such as high-yield or international bonds) also benefit from the diversification and professional management offered by bond funds. For these types of bonds, we strongly recommend the diversification offered through bond funds, not an individual-bond approach.

Scenario: A retiree desires liquidity
Solution: Bond funds

You can redeem shares of bond funds at any time for the day’s closing market value (net asset value, or NAV) of the fund, minus any applicable redemption fees. Individual bonds can be sold prior to maturity, as well, but the price could be significantly more or less than the original investment. In addition, some bonds are more liquid than others, and during periods of market volatility, those that lack liquidity might experience significant price volatility.

Scenario: A retiree who wants to reinvest income payments automatically
Solution: Bond funds

Retirees still focused on long-term growth and less on income—such as those with pensions or other fixed incomes—might choose to reinvest interest payments/dividends in new mutual fund shares. The ease of reinvestment is one big advantage bond funds have over individual bonds, though it's less of a benefit for retirees focused on income generation.

Scenario: A retiree wants protection should interest rates rise
Solution: Bond or bond funds

Retirees might also worry about the impact to their bond portfolios should interest rates rise. One way to guard against rising interest rates is through bond laddering. With a bond ladder, you invest in several bonds with staggered maturity dates, and benefit from higher rates for bonds with longer maturities while also having money to reinvest from shorter-term bonds when they mature if interest rates rise. With bond funds, you can rely on the fund manager to manage a portfolio of bonds designed to take advantage of changing rates, whereas you'd have to manage the ladder yourself if you choose to invest in individual bonds.

When interest rates rise, bond funds experience a short-term hit to price. Over time, however, income can make up the bulk of bond fund returns, and those returns will generally overcome the short-term hit to price. Furthermore, the income from the same fund in a higher interest-rate environment will be higher, as well, though if interest rates rise steadily over time, it could take awhile for the increased income to offset capital losses.

Bonds and bond funds each have significant advantages and disadvantages when it comes to retirement-income generation. It's likely that retirees will choose a mix of both in order to achieve their various income needs. For help deciding which investment is best for your income needs in retirement, call your Schwab financial consultant, or contact our Fixed Income Specialists at 800-626-4600.