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Bonds vs Bond Funds ???

Updated on December 7, 2012

Understanding Fixed Income

While over the years the community of investment professionals nearly universally agree that most every client should own some form and percentage of fixed income as part of their asset allocation strategy…Over the years there has been an ongoing debate among both professionals as well as individual investors as to whether or not it is more advantageous to buy bonds and other fixed income instruments individually or to utilize a bond fund. While there can be valid arguments on both sides of this discussion, the answer often depends on the individual client circumstance.

What are the advantages of individual bonds…The primary and most often quoted advantage is generally that buying an individual bond will provide you with a stated maturity date. Because of this, barring a credit default, you can know a precise rate of return at purchase should you hold the security until maturity. Secondly, there is no internal expense associated with holding an individual bond. Once the security is purchased, you are not subject to paying the fund expenses associated with a bond fund.

What are the advantages of bond funds…The primary advantage is that of diversification. A bond fund can provide you with the ability to own multiple positions across the corporate, treasury, gov’t agency & municipal markets. As in owning stocks, it is generally not a good idea to have all of your fixed income investments tied to one instrument when building a long term investment portfolio. This can be difficult to do efficiently with individual bonds unless it is a sizeable portfolio. The other more commonly stated advantage is active management. Much like stocks, fixed income investments fluctuate in value, and are subject to price changes throughout the day. Just because a security has a stated maturity date does not mean you must hold it to such a date. In many instances it is in your best interest to sell a fixed income position and realize a capital gain to reinvest the proceeds in yet another instrument. This has been particularly true over the last few years in which we have seen a rapidly declining interest rate environment. Much like refinancing a mortgage, if the market conditions are favorable it may be in your best interest.

The question as to which option is better depends on many factors. In the instances where you can clearly see an extremely short term financial goal, buying individual short term CD's or a T-bill is often the right approach. Something as basic as the need to have funds available for a real estate closing in the next 12 months would be such an example. However when we start to look further down the road at a longer term investment portfolio, often diversified fixed income funds are much more beneficial than most realize. One such reason is actually pricing. While it is true that a fixed income fund will have internal management fees and trading costs, this often pales in comparison to the egregious pricing system in the bond market. While you may not pay an ongoing fee when buying an individual bond, the real question is what did you pay up front??? In the stock market if you request a quote at 2 pm for stock in IBM, you’ll find the quote at that precise second is largely universal. It comes directly from the exchange where the bid & ask prices from all investors meet at the same time and place. The pricing system in the stock market, while more volatile, is actually extremely efficient. In some respects its efficiency may actually contribute to volatility.

However the bond market functions in a completely different manner. The price the average investor is receiving in a bond trading in the secondary market can be vastly different than that of which another investor or fund manager is receiving. The best way to envision this is to think of the last time you bought a car. You most likely negotiated for the price you felt was equitable. However, had you been buying 50 cars that day…would you have had more negotiating power??? The answer is likely yes. The same is true in the fixed income markets. Brokerage firms and their brokers most often are selling bonds directly from their fixed income inventory they hold in the firm. They have a great degree of latitude in how much they will charge you. Often they may prefer to sell you a bond in house that is more profitable for them to mark up then to go out to a bond dealer and complete a purchase for you in an issue that may be a better investment, simply because the profit margin is lower. In the case of a large fixed income fund, a fund manager operating as a professional portfolio manager can shop the entire fixed income market while looking for the best yield and simultaneously negotiate price due to the size of the purchases. While analyzing the cost of any fund is important since fund expenses can vary greatly, the internal expenses are very often justifiable when looking at the value added.

What about the risk of price volatility in bond funds due to the fact that they do not have a stated maturity date ??? This is a concern, but not a serious concern if you construct your overall investment strategy efficiently. Bond funds are offered with many different objectives, from short term funds to intermediate and long term funds. Depending on the interest rate environment and your personal risk profile you can simply manage this volatility by weighting your average maturity through the types of funds you buy. For example, if you were highly confident that interest rates where to rise you can simply weight your portfolio towards shorter terms funds that will show nominal price movements while offering you lower dividend income. Laddering bonds is often a strategy that investors use when building an individual bond portfolio. This can be done with funds by purchasing multiple funds with different objectives.

Furthermore the pricing of individual bonds in an investor’s portfolio is often misleading. Brokerage firm’s price fixed income investments in what is known as a “matrix pricing system”. This is a system in which the average price of many fixed income investments with similar maturity dates, credit ratings and callable features are calculated. This average price is then placed on your monthly statement as the current value. However should rates decline and you wish to sell a bond early for a profit, you will be subject to having to have your broker go to the market place and request an actual bid the market is willing to pay or have them make you an offer and add the issue back to their inventory. While there are rules and parameters in terms of how much an issue can be marked up, it is unlikely that the average investor will get anywhere close to the best price possible. Additionally this pricing system is far from transparent. Your broker is not even legally required to disclose how much the markup was. Considering the importance of rebalancing an investment portfolio through volatile markets, it is common not to consistently hold fixed income issues to maturity. And in reality, the price on your statement is essentially a myth.

In general, we favor fixed income funds over buying individual bonds in the majority of cases. However there are always examples of exceptions. The greater question is active management of fixed income over index funds or ETF’s. While we are great advocates of ETF’s in equity investing, the opposite is often true in fixed income investing. Due to the pricing mechanisms mentioned above, a good fixed income manager can be invaluable. The statistics of fund performance relative to the benchmarks is similar to the equity markets. Only about 40% of funds managers per year outperform the Barclays Aggregate Bond Index. However, the group of outperforming managers seems to be much more consistent when compared to stock portfolio managers whom seem to rotate from top to bottom routinely.

As always each client circumstance is unique and need to be addressed as such.


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      paulcsorba 

      6 years ago

      You're right on with this. Good stuff.

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