Bonds vs. Bond Funds
Once a suitable bond allocation has been determined, the next decision is how to implement the investment strategy. Options include a professional managed bond fund, a professionally managed separate account, or a self-directed portfolio of individual bonds. It’s important to note that there are material differences between traditional bond funds and Exchange Traded Funds (ETFs).
Exchange Traded Funds
Expense ratios of Exchange Traded Fund are usually less than those of similar traditional mutual funds. Relative to actively managed bond funds, index-oriented bond funds and ETFs have low costs and low manager risk, so they are less likely to significantly underperform an index. Like traditional index funds, ETFs generally hold the same securities or a representative sample of those securities in the target index.
However, unlike traditional index funds, Exchange Traded Funds are traded like individual securities on national exchanges. Therefore, with an ETF, flexibility such as trading throughout the day is available. This trading flexibility comes with a price: investors incur bid/ask spreads whenever they buy or sell ETF shares. In addition, there can be some variance between the market price of an ETF and the net asset value (NAV) of its underlying portfolio of securities.
Traditional Bond Funds
Bond funds typically provide broader diversification than is possible with individual separate accounts. This greater diversification is possible because a bond fund generally has a larger pool of assets to invest, thus allowing a bond fund manager to diversify widely and cost-effectively.
A bond fund typically allows for both timely implementation of an initial bond investment and rapid reinvestment of interest payments. Because of regular cash flows, bond funds are also better able than individually directed portfolios to maintain stable portfolio characteristics over time.
The bond fund structure furthermore facilitates liquidations, especially partial liquidations, without compromising the risk characteristics of the portfolio. In a bond fund, an investor can purchase a proportionate share of a completely constructed portfolio with a single transaction. An individual bond portfolio, by contrast, typically takes time to build.
Bond funds commonly pay monthly dividends to their shareholders based on each client’s proportionate share of the interest received by the fund from the individual bonds that it owns. Investors can either opt to have these dividends paid out to them or have them automatically reinvest in the fund.
In a self-directed bond portfolio, cash from bond coupon payments or new investments may need to accumulate until there’s a sufficient amount to invest and/or until the bond of choice is available. A bond fund’s more timely investment of new cash and reinvestment of income can reduce the “cash drag” on portfolio performance.
Liquidating fund shares does not change a bond portfolio’s overall risk profile. However, liquidating an individual bond from a portfolio may require selling a whole bond which may alter the portfolio’s overall risk characteristics.
Bond funds and separately managed accounts charge ongoing fees for portfolio management. Bond funds charge an ongoing management fee for fund operating expenses. These fees include the cost of portfolio management as well as legal, accounting, custody, and record keeping services. Because the cost of these services is shared over a large asset base, bond funds can typically provide all these services at lower costs than separately managed accounts.
Because the size of a bond fund’s individual bond trades usually exceeds that of a separately managed account, the fund has more opportunity to minimize transaction costs. For example, the bid-ask spread tends to vary by trade size and bond sector, and the size of the spread is typically larger for small transactions. As long as bid-ask spreads are inversely related to purchase lot size, the strategy with more resources has an advantage.
Scale can also influence opportunity costs incurred in different accounts. For example, a smaller separate account or self directed investor can easily reduce transaction costs by purchasing fewer securities. Yet this seemingly sensible decision produces an opportunity cost: potentially lower returns and reduced diversification. If a portfolio doesn’t have sufficient assets to diversify widely, the best way to reduce default risk is by concentrating in bonds of the highest quality, thus sacrificing the potentially higher returns from lower quality issues. A large bond fund, by contrast, can hedge default risk by diversifying widely across lower quality bonds, minimizing the effect of any one default while capturing the returns available from lower quality securities.
In the final analysis, bond funds provide investors with advantages over individual bond portfolios that include diversification, cash flow treatment, liquidity and cost advantages.
Separate account fixed income managers, in an effort to win lucrative fees, often assert that within a mutual fund, after a period of falling interest rates, hot money chasing recent performance will typically buy into the fund. The fund, therefore, must buy more bonds in a low rate environment. If rates increase the hot money leaves, forcing the fund and long-term investors in the fund to suffer capital losses that can’t be waited out. Each investor carries his or her own cost: if one investor redeems at a loss and the bond fund manager needs to raise cash through the selling bonds, any loss or gain will be distributed proportionally.
While owning bond mutual funds can provide advantages, there are advantages to owning individual bonds. These advantages revolve mainly around more control over which bonds are held in the portfolio and avoiding operating expenses of the fund.
A further advantage for owning individual bonds for taxable accounts is that an investor can manage taxes at the individual security level. A mutual fund investor is only able to harvest tax losses at the fund level. Another benefit of owning individual bonds is that investors can take 100% control over the credit risk and the term risk of their portfolios. They can also take control over the timing of cash flows from the portfolio. This is helpful for investors relying on their fixed income assets to provide cash flow for spending. But gaining these advantages is generally offset by higher transaction costs, less liquidity, and greater risk.
There is no right or wrong answer as to whether individual bonds or mutual funds are superior. The answer will depend on the unique situation of each investor, as well as the preference for convenience versus control. Some investors may be willing to pay the premium and forego mutual funds for greater portfolio control. However, the vast majority of investors are probably better served through low-cost bond mutual funds.