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Bond Funds Or Individual Bonds? That Is The Question

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As investors peruse their options in the fixed-income space, one of the major questions they’ll be faced with is whether to utilize funds either via open- or closed-end funds, ETFs, or individual issues. Each option offers its pros and cons, and the answer is probably not clear cut from investor to investor.

I’ve listed a number of initial considerations in the matter:

  1. How much money are you investing?
  2. How much time can you devote to researching your bonds?
  3. Do you have an opinion on the future direction of interest rates?
  4. What is your general risk tolerance for the bond position?
  5. What are your general goals for investing in bonds?
  6. What kind of bonds are you investing in, or are you partial to?
  7. What are your yield requirements?

To see a list of high yielding CDs go here.

If you are just beginning or have limited funds in which to invest, bond funds are probably a good starting point. Bond funds provide transaction ease, professional management, and instant diversification. Of course all of that comes at a defined cost, usually somewhere between .25 and 1.5%, annually, of the assets that you entrust to the manager. With rates at historical lows, fees can dramatically eat away at the net yield that a bond fund returns to an investor.

Though funds and ETFs offer diversification, when you buy a pooled product you are essentially buying the characteristics of one bond. What I mean by that is all the bonds combined with the portfolio create a blended maturity and credit profile. For example, BND, Vanguard’s Total Bond Market ETF sometimes considered a one-stop shop for bond investors has the following asset and maturity characteristics:

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It also offers the following issuance and credit profile:

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So when it comes down to it, although BND holds better than 6000 positions, you are essentially buying a heavily skewed U.S. Government bond fund with a paltry yield of 2.1%, duration of 6 years, with no issues rated outside of investment grade. When you evaluate a pooled product, you must take into account the blend of the underlying assets to understand what it is you are really buying into. As blended duration rises and credit quality lowers, you can find better yields, but your risk goes up as well.

And depending on the type of fund you buy into, the profile could prove to be rather fluid. If you have a manager who’s offered flexibility by the fund’s charter, it’s possible that as bonds mature and are bought and sold that the credit/maturity profile can change over time, creating more or less risk than one initially thought they were buying into. So certainly monitor a fund on a semi-frequent basis.

Funds also expose one to NAV fluctuation of an indeterminate nature. In a dovish environment this is generally positive, in a hawkish world, not so much. Individual issues also subject investors to interim price fluctuation, however, an individual bond boasts a defined maturity date, while funds provide no back-end guarantees.

When we consider individual issues, we eliminate ongoing fees and surprises, and can craft yield, credit quality, and maturity to suit personal tastes. Unless called or a black swan event occurs when one buys an investment grade issue, capital is generally rock solid and returned at a defined date. For investors with the capital and ability to buy a diverse group of high quality issues, I strongly suggest individual bonds.

The one time that I think even more refined bond investors should consider a fund is when delving into high-yield. Though junk defaults continue in the very low single digits, a sharp deviation of economic prospects can create havoc in the junk market – like what we saw during the financial crisis in ’08-09. Though an event like that may actually prove to be a high-yield buy opportunity, if you are overweight junk debt, it may be a difficult situation to hold through.

Of course not all high-yield debt is the same. There’s a big difference between a bond rated BB+ (one step away from investment grade), and a bond rated somewhere in the C’s (high or imminent risk of default). So high-yield investors, fund or not, should have keen understanding of how much risk they are really taking.

Though funds serve a purpose for some bond investors, over the long-term avoiding fees, decreasing risk, and creating a personalized portfolio should be the ultimate goal.


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About the author: Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.

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Adam Aloisi

Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.

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