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Deciding Between Individual Bonds and Bond Funds

Written by BAM

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We use both individual bonds and bond funds for our clients. It can be confusing why one strategy for buying bonds is preferable to another, but in reality the reasoning is fairly straightforward: It comes down to costs, diversification and liquidity needs.

Individual Bonds

Our overall approach to investing emphasizes taking risk through a diversified stock fund portfolio and reducing risk by holding high-quality bonds. We believe investors who follow this approach can generally benefit from holding individual bonds instead of bond funds once the bond portfolio reaches $500,000 or more in value. This, of course, assumes the individual bonds are bought in a transparent and low-cost manner, which, unfortunately, is not always the case when individual investors buy bonds.

Costs

When individual investors purchase bonds, the typical experience — whether it is disclosed or not — is that these bonds are sold out of a broker’s inventory and are “marked up.” A markup simply means the brokerage firm bought the bonds for one price and sold them to a client for a higher price. For example, the brokerage firm may have purchased a tax-exempt municipal bond for $100 and sold it for $102, which is a 2 percent markup. In our experience of analyzing broker-built municipal bond portfolios, we have found that most bond purchases are marked up between 1 and 2 percent. From a yield perspective, this price markup translates into a loss of roughly 0.20 to 0.40 percent of yield for a five-year bond.

We, on the other hand, have no inventory and no ability to mark up bonds. Our clients only need to worry about the price of the bond that we acquire on their behalf. We typically buy tax-exempt municipal bonds at prices that are about 0.1 to 0.2 percent higher than the price the brokerage firm paid for the bond. This, as noted, compares with a cost of 1 to 2 percent that most individual investors incur. Further, this means a small fraction of yield is “lost” upon purchase, roughly 0.02 to 0.04 percent for a five-year bond.

This leads us to the potential advantages of building out an individual bond portfolio when costs are low. The primary cost advantage is the investor avoids paying the fund expense ratio, which is typically between 0.15 and 0.30 percent for a low-cost fund. On a year-to-year basis, cost savings of this magnitude add up.

Diversification

We have long argued that stock investors should be more than happy to pay a low fund expense ratio in return for the diversification a stock mutual fund can provide. Since any company can go bankrupt or experience very poor stock performance, it helps to own a large number of stocks to reduce company-specific risks such as a failed product offering, a successful CEO having health problems or any other example you can come up with.
With high-quality bonds, however, diversification is not nearly as important. For example, if you own one U.S. Treasury bond, buying a CD does not improve diversification because the U.S. Treasury bond is broadly considered to be the highest-quality security in the world’s markets. Of the bonds we buy, municipal bonds are a slight exception to this rule. We believe you should have no more than 10 percent of your portfolio in a single municipal bond issuer, but once a bond portfolio approaches $500,000 to $1 million in size, the allocation to any single municipal bond issuer can easily be kept below 10 percent.

Liquidity

Investors who have withdrawal needs that cannot be covered by stock fund dividends and principal and interest payments on bonds will likely need to keep some portion of their portfolio in bond funds. Bond funds can be sold with minimal cost, so they can be useful when liquidity needs cannot be met by other sources. However, allocating the entire bond portfolio to bond funds may mean the investor is paying for liquidity that is not needed. So, the bond portfolio needs to reflect the actual liquidity needs of the investor. Solely using either individual bonds or bond funds cannot be the right approach for all investors.

Other Considerations

Tax and credit risk customization are two other potential advantages of using an individual bond portfolio instead of a bond fund. Tax circumstances vary from one investor to another. Tax-exempt municipal bonds make sense for some investors but not others. California residents may want to have a portion of their portfolio in California municipal bonds because of their double tax-exempt status. Residents of other states, however, should probably minimize their exposure to California municipals because better risk-adjusted returns are likely available from other issuers. Further, some investors may want to limit their municipal bond holdings exclusively to Aa- and Aaa-rated bonds to minimize credit risk.

These customization opportunities can be accommodated in an individual bond portfolio but not through a bond mutual fund because it is designed to be generally suitable for a large range of investors.

Examining Critiques of Individual Bond Portfolios

Relative to bond mutual funds, common critiques of individual bond portfolios are the risk of bonds defaulting, the potential high costs of implementation and the lack of reinvestment of coupon interest.
Because we focus on high-quality bonds, the risk of a bond defaulting is very low. We primarily focus on Treasury Inflation-Protected bonds, U.S. government agency bonds, municipal bonds and CDs. Of these four categories, municipal bonds are the only one that has any measure of default risk. However, even rated municipal bonds have defaulted very infrequently. Over the period of 1970–2011, there were only 71 defaults on municipal bonds that Moody’s rated. This compares with 261 corporate bond defaults in 2009 alone. Therefore, if your portfolio is focused on high-quality bonds, investing in a bond mutual fund may mean you are paying a fund expense ratio when diversification is not needed. If instead you are focusing on lower-quality bonds such as corporate bonds, which of course we do not generally recommend, you absolutely need the diversification that a bond fund provides.

We often hear that the purchasing power of large institutional buyers, such as mutual funds, leads to lower transactions costs than individual bond buyers incur. While it is true that trading costs tend to decline for such large institutional buyers, we also find that yields are lower for larger purchase sizes compared with smaller sizes. In effect, these large institutional buyers are paying for ease of trading (as the old saying goes, “there’s no free lunch”). Investors who generally plan to hold bonds to maturity can potentially benefit by buying these smaller bond sizes that most institutional investors avoid because these smaller bond sizes tend to have higher yields. As noted above, the cost associated with an individual investor buying bonds through a broker is typically much higher than an institutional investor buying bonds on behalf of its clients in a transparent manner. These two scenarios cannot be treated as equal from a cost perspective.

A common argument for bond funds is interest payments can be reinvested with ease compared with an individual bond portfolio, where interest payments may sit in the account until enough cash accumulates to purchase another bond. In practice, however, a diligent system for monitoring cash holdings and effective use of bond funds can mitigate this issue. We frequently reinvest individual bond interest payments into bond funds until enough cash accumulates to purchase a bond. Efficient reinvestment of cash is rarely an issue because our custodians offer both no-transaction-fee bond funds as well as low-cost bond funds with minimal transaction fees. Further, for larger portfolios, the interest payments are large enough and frequent enough that an individual bond can be purchased directly with those interest payments.

Summary

We believe individual bonds and bond funds can serve important roles in your portfolio depending on your circumstances. We generally find that individual bonds are the better choice for investors with bond portfolios of $500,000 or more, while bond funds are generally more appropriate for portfolios with less than $500,000 in bonds. When bonds can be acquired at reasonable cost, the advantages of individual bonds include lower costs, potentially higher yield, and opportunities to customize the portfolio around tax circumstances and credit risk concerns.


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Copyright © 2013, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

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