February 5, 2009

Downside of individual bonds: simple interest

Here is a point I found in the Wall Street Jones blog article Should You Buy Municipal Bonds Individually or in a Fund?

They point out "If you own small lots of individual munis, you earn simple interest – not interest-on-interest. Say you hold a muni with a 5% yield to maturity. If you put your semi-annual coupon payments into a bank account yielding 0.5%, then your true yield over time will fall well short of the stated yield to maturity. A mutual fund, on the other hand, invests in bulk so it can plow the interest earned by its bonds directly into more bonds at market yields."

Individual bonds pay simple interest whereas bond funds can get you compound interest.

So why is simple interest so bad? Lets look at an example.

Consider if you've got $10,000 to invest. You could buy a single bond or a bond fund.

Option 1: Single Bond
Lets say you buy Municipal a bond with a coupon of 5% and face value of $10,000. The maturity date is 10 years from now. It pays you $500 every year. But you don't make that 5% interest rate on your interest payments. You get a $500 payment every year and then you'll have to find somewhere else to put that $500. If you put your bond interest into a high yield savings account making 2% then at the end of 10 years you would have a total of $15,474 and change including the principal.

Option 2: Bond fund.
If on the other hand you put your $10,000 into a bond fund then you can easily pump your $500 dividend yields back into the bond fund. Lets say every year you take your yield and buy more of the fund in question. If you have a $20 annual fee to buy the fund but it yields a consistent 5% then at the end of 10 years you'd have $16,819 total.

With simple interest the individual bond would net you $5,474 in interest and the compounding interest of the bond fund would net $6,819 interest. That's a $1,345 difference simply due to compounding.

Note that the bond fund is not going to yield a steady 5% every year for 10 years and I'm just using that assumption to make the example easy. One big negative for bond funds is that the rate will fluctuate which can be good or bad.

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