I have heard many pundits say that retail investors should simply invest in broad-market index funds because even top professionals in the business struggle to outperform the indices over the long run. Perhaps that is true regarding stocks. In the world of bonds, however, I think it’s quite easy to outperform the major indices over the long run.
As I built my diversified portfolio of individual bonds, I came to appreciate the advantages retail investors have over fund managers. For example, managers of non-defined-maturity funds typically maintain relatively constant durations, thereby causing certain bonds to be sold not because it is the ideal time to sell that bond, but rather because the fund’s mandate requires that bond to be sold. People who invest on their own behalf have the luxury of determining whether it is better to hold the bond to maturity or sell it early.
Additionally, retail investors aren’t constrained by other rules under which a fund operates, such as only being able to invest in notes with a certain amount outstanding. If you want to invest in an issue with only $100 million outstanding, and you’re comfortable with the illiquidity risk, you can do that. Fund managers, however, don’t always have that luxury. Furthermore, you’re never constrained with only being able to invest in bonds that mature in certain years (like defined-maturity funds). You’re never forced to take risks you’re not comfortable with, such as, perhaps, having an allocation to C-rated bonds. And you’re never forced to take too little risk, such as, perhaps, having too large an allocation to the highest-quality and lowest-yielding bonds. Finally, as an individual investor, you need not worry about keeping your job if you underperform an index in any given year. That allows you the freedom to take risks that will help you outperform bond indices over the long run.
In short, when building an allocation to bonds, you have much more freedom than fund managers. That freedom allows you to build a portfolio that suits your portfolio goals, your income needs, your time horizons, and your risk tolerance. While in the past it was a valid critique that individual bond portfolios were expensive to build, that criticism no longer holds any water. With retail brokerages now offering commissions as low as $1 on corporate bonds, municipal bonds, and secondary-market CDs, and no commissions on Treasuries and new-issue CDs, there is no excuse for paying outrageous commissions and markups. Moreover, with the ability to hold a bond to maturity and the ability to enter limit orders on your trades, you can choose whether to accept what you consider an unusually low bid or continue to hold the notes.
It has always struck me as odd that so many retail investors are confident in their stock-picking abilities but fearful of buying an individual bond. It’s as if investors have forgotten which asset is higher up the capital structure. Keep in mind that in today’s ultra-low interest-rate environment, giving up yield to a fund manager (in the form of expenses) and settling for the returns provided by an index are not necessary when you have certain advantages over the pros.
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