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Bonds vs. Bond Mutual Funds

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bond-index-fundsSo What’s Better? Investing in individual Bonds directly or through a Bond Mutual Fund?

The short answer is “it depends” and there really is no single correct answer. There are potential benefits and drawbacks to each, and ultimately the decision may boil down to many factors including dollar amount to invest, personal preference, and segment of the bond market under investment consideration in addition to factors such as risk tolerance and investment objective. Some aspects of each vehicle are not always applicable to one another and make comparisons difficult. Various aspects of each individual bonds and bond mutual funds are discussed below in order to educate investors on making the right decision.

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Liquidity

Liquidity, the ease and cost-effectiveness with which a security can be bought or sold, is one of the more notable potential advantages mutual funds hold over individual bonds. A bond mutual fund can be easily bought or sold in small dollar amounts and this can be particularly important during periods of market stress. Depending on the specific bond and quantity, an individual bond investor may encounter more difficulty selling into a stressed market. A buyer with a small dollar amount can indirectly access a diversified bond portfolio via a bond mutual fund. Individual bonds may involve certain investment minimums such as $5,000 for a municipal bond and $25,000 for a GNMA, which restricts individual bond investment for smaller investors.

The bond market has historically been dominated by institutional investors and orders of $1 million or more have been certainly preferable by bond dealers. For smaller trades, a wider bid-ask spread (difference between buy and sell prices) exists and this creates a hidden cost. Bond dealers or traders may require wider margins on smaller trades either to make it cost effective or because the small lot may be more difficult to sell in the future. For example, a sell order of $25,000 worth of bonds may involve a mark down of .25 to .5 points (or more depending on the specific bond) relative to an order of $1,000,000. Additionally, thinly traded bonds can involve a price concession when it’s time to sell. All this increases costs for individual bond investors.

Among individual bonds, liquidity is best for top-quality Treasury and non-callable agency securities compared to corporate, mortgage-backed, and municipal bonds. This is also reflected in mutual funds where higher average expense ratios exist for corporate and municipal funds according to Morningstar data. While $1 million is considered the lot of choice overall in the bond market, smaller trade amounts are much less of an issue with Treasuries and agencies. For example, an investor buying $10,000 worth of a Treasury or agency bond may involve only a minimal .125 price concession ($12.50) if any.

Diversification

Another potential benefit of bond mutual funds is diversification. Bond mutual funds offer instant diversification and help avoid wide performance swings that may result from one poorly performing individual bond position. Credit risk can be a problem with corporate bonds and holding just a few lower-rated bonds may not be prudent. Credit risk is not an issue with Treasuries (principal and interest is guaranteed by the government) but investors may still wish to diversify maturities.

In addition, bond funds provide access to certain segments of the bond market that are more difficult for individual bond investors to access. For example, asset-backed bonds and adjustable rate mortgage-backed securities are still very much institutionally oriented and trades for less than $250,000 can be difficult to come by. Bank loans are another asset class that individual bond investors cannot access and default risk and illiquidity in the high-yield bond market prohibits small individual bond investment. Foreign bond investing with currency issues and liquidity challenges, especially among emerging market bonds, can also pose serious challenges to individual bond investors. Funds that focus on these segments of the bond market can offer advantages versus buying individual bonds, which can be prohibitively difficult for certain sectors.

Diversification can be achieved via individual bonds but larger dollar amounts are required to do so cost effectively. A sum of $250,000 may be a bare minimum to obtain a minimal level of diversification via individual bonds depending on the bonds utilized. With that said, diversification is less of an issue for Treasury and agency bond investors due to high credit quality and the ease of purchasing smaller amounts.

Now that we’ve discussed the two primary advantages of bond mutual funds, it’s important to mention a caveat. With regard to individual bonds, the greater the amount to invest, the more the advantages of mutual funds above are negated. For larger dollar amounts, such as a portfolio of $1,000,000 or more, it becomes more feasible to create a diversified individual bond portfolio with adequate diversification and sufficient liquidity enabling fixed income investors to save on expenses.

Interest Rate Risk

How an individual bond portfolio or bond mutual fund reacts to rise in interest rates is determined primarily by duration, a measure of interest rate sensitivity. Interest rate changes affect both individual bond portfolios and bond mutual funds with duration being the primary determinant of how much prices change, either up or down for a given interest rate shift. Duration for an individual bond portfolio can be easily calculated and the average or effective duration of bond mutual funds is readily available. All else equal, the greater the duration, the greater the interest rate sensitivity and vice versa. Individual bond investors can compare their portfolio sensitivity to that of the Barclays Aggregate Bond Index, a widely followed bond benchmark, to determine whether they have more, or less, interest rate sensitivity relative to the broad market.

A common misbelief among investors is that individual bonds will be less volatile compared to a mutual fund. This belief is perhaps based upon a perception that if held to maturity, individual bond investors will receive their principal back upon maturity and maturity date acts as a stabilizer. Over a long period of time, this is true if the bond portfolio is simply held to maturity and bonds move closer to maturity date with each passing year. Some bond funds maintain interest exposure fairly close to a target benchmark such as the Barclays Aggregate Bond Index, where duration has fluctuated between a narrow range of 3.5 to 5.5 years over the past 10 years.

Expenses

According to Investment Company Institute data as of 12/31/12, the average bond mutual fund charges 0.61% annually in expenses. For a $1,000,000 portfolio this amounts to $6,100 annually and does not assume up-front load costs, if any, paid upon purchase.

Consider the following hypothetical example based upon Bloomberg trade data. Let’s assume an investor decides to invest $1 million in individual bonds, 10 bonds of $100,000 each. Assuming a markup of .125 (due to 100k pieces vs. $1 million round lot) and per bond fee of $25, this equates to $1,750 ($1.25 per bond times 1,000 bonds total plus a transaction fees of $500 for ten bonds). In this hypothetical example, the total cost of the bond portfolio is $1,750 versus $6,100 for the fund. Assuming a larger markup of 0.25 the total cost rises to $3,000 but still below annual fund expenses. Depending on the number of bonds purchased, whether it is a buy and hold investor, or how much is Treasury/agency based, individual bonds could provide cost savings at small dollar amounts.

Of course, embedded in a bond fund’s annual expenses is a valuable service: professional money management. Although a “do-it-yourself” individual bond investor may be able to construct a well-rounded bond portfolio on their own and save costs initially, the management fee embedded in a fund’s expenses may be a small price to pay for the time and expertise to manage a bond portfolio. Over time a professional bond manager, including a team of analysts and trading capabilities, may lead to better investment performance that can more than offset any cost savings from fees and transaction costs.

Interest Payments

Bond mutual funds seek to provide the convenience of monthly interest payments but the vast majority of bonds, on the other hand, pay interest semiannually. This requires a larger number of bond holdings with different maturity dates (remember interest payment cycle goes off maturity date) to achieve the same monthly income distribution. Some individual bonds pay monthly but such bonds are not available in all sectors and are often limited to specific issuers, which can work against constructing a diversified bond portfolio.

Due to the fixed rate payment, individual bonds provide a level of income that is known with certainty absent a default or maturity. In this way, individual bonds allow an investor to “lock in” in rate of income. On the other hand, bond fund distribution yields can fluctuate with market interest rates higher or lower.

Yield

Comparing yields between bond funds and individual bonds is not as straightforward as it seems. Yield to Maturity (YTM) is the focal yield measure when considering the purchase of a bond. It is a total return measure that takes into account: 1) total cost of the bond at time of purchase, 2) interest payments over the life of the bond, 3) interest earned on interest payments, and 4) redemption value at maturity. A key assumption of YTM is component #3 where interest payments are reinvested at the YTM rate (more on this later).

A bond fund does not have a maturity and therefore, no YTM. The distribution yield quoted on bond funds (such as the 30-day SEC yield) is a variant of the “current yield” of an individual bond. Current yield is merely annual income divided by price for a bond. Many bond fund managers purchase premium issues to keep income high. In this way, fund management hopes to make the fund more attractive to investors as the distribution yield is more frequently cited. Bond funds do publish the average YTM of the underlying portfolio regularly and individual bond investors can compare to the YTM of their portfolio.

One challenge to the YTM expected by individual bond investors is the interest-on-interest component of the YTM formula mentioned above where it is assumed the investor diligently reinvests all interest payments in a timely manner. In reality this may be difficult to do, as bondholders of smaller positions will have to let cash accumulate in a lower-yielding money market fund before having a sufficient amount to purchase more bonds. Failing to reinvest at the same, or higher yield, than the initial YTM likely lowers the realized return over time. With a mutual fund, interest payments can be automatically reinvested into the fund and more bonds. This makes it easier for investors to compound their interest. This is not really an issue for larger bond investors who can reinvest an interest income more easily.

Maturity Date

Individual bonds, unlike mutual funds, have a set maturity date, which can allow investors to more specifically target a financial need. For example, an investor with a known financial obligation 18 months from now can purchase a bond with the same maturity date to exactly match the funding need. A short-term bond fund does not afford the same convenience and can subject an investor to interest rate risk or credit risk right up until the date money is needed. Similarly, funding needed between 10 and 15 years in the future can be met with a portfolio of bonds maturing over the time frame. A mix of bond mutual funds could also be used but have to managed and changed over time.

Conclusion

In sum, both individual bonds and bond mutual funds can provide effective bond exposure for investors. Bond mutual funds provide liquidity, diversification, and outsourcing of bond management while the argument for individual bonds can provide potential cost savings, greater income certainty, and help meet more targeted funding needs. Factors to debate involve personal preference such as delegating management to an outside professional rather than the “do it yourself” approach with individual bonds. Control is another key element and boils down to personal preference; some investors exhibit greater desire to control their tax situations. Other nuances such as interest payments and maturity (or lack thereof) are also personal preference issues.

 

About Anthony Valeri

Anthony ValeriAs Senior Vice President and Market Strategist, Anthony is a member of the Research department’s tactical asset allocation committee and is responsible for developing and articulating fixed income and general market strategy. Anthony regularly communicates market strategy to LPL Financial advisors, contributes to the Research department’s flagship publications, is a speaker at LPL Financial conferences, and authors Bond Market Perspectives, a weekly client commentary on the bond market. Anthony has been quoted in a number of national online and print publications including Bloomberg News, Reuters, and Dow Jones. Prior to joining the Research Department in January 2002, Anthony was Head Trader of the LPL Financial fixed income-trading desk. Anthony has 18 years of investment experience.

Anthony received a BA in Quantitative Economics and Decision Sciences from the University of California at San Diego in 1992 and received his Chartered Financial Analyst designation in September of 1999. Additionally, Anthony is Series 7 and 63 registered. Anthony is a member of both the Association for Investment Management and Research and the Financial Analysts Society of San Diego. Anthony has been with LPL Financial since June 1993.

Important Disclosures

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly

A marketable, fixed-interest U.S. government debt security. Treasury bonds make interest payments semi-annually and the income that holders receive is only taxed at the federal level.

Bonds are subject to market and interest rate risk if solid to maturity. An investor can lose money when investing in government bond funds. The fund itself is not guaranteed and fund’s performance will vary. An increase in interest rates may cause the price of bonds and bond mutual funds to decline. Bank loans are loans issues by below investment-grade companies for short term funding purposes with higher yield than short-term debt and involve risk.

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