July 11, 2022 | Cameron Parkhurst
As a consultative partner to many RIA firms, we often receive questions from Advisors and their clients trying to decide whether they should invest in individual bonds or bond funds. There are tradeoffs with each approach, and the specific answer to this depends on the investor’s financial situation and objectives, including their risk tolerance and time horizon. In thinking through this decision, it is helpful to understand the ins and outs of each, and how they compare.
Individual Bonds
Individual bonds at the fundamental level are issued debt instruments. As the purchaser of a bond, you are lending your money for a set time period. In exchange, you will receive interest payments on a schedule until the date of maturity, usually on a semi-annual basis. At maturity, you will receive your original loan amount, or “principal”.
The key benefits to owning individual bonds (assuming no defaults) are:
Reliable income stream. Most individual bonds pay a determined interest amount at pre-set intervals (usually semi-annually). This allows the investor to plan for their income needs over time.
Predictable value at maturity. As the bond approaches its maturity date, the price will converge towards its par value. Par value is paid at maturity, which allows the investor to know with certainty the amount of investment they will receive at a future dat. This assumes the bond is now callable which can result in an earlier return of capital.
Cost basis. Investor has their own cost basis, which assists with tax-planning.
Bidding Bonds. Using a capitalized inventory to bid bonds, especially odd lot sizes, can lead to price advantages and increased yield for the buy and hold investor if using a professional individual bond resource. This, however, becomes a more detailed discussion when actively trading, as trading spreads are involved.
Customization. Maturities, coupons, and credit quality can be customized around any RIA’s client-specific needs.
Relative Value. Ability to focus on those sub-asset classes that are most attractive for the credit risk being taken in any market environment.
The key downsides to owning individual bonds are:
Higher dollar amount needed to achieve appropriate diversification. Typically requires at least a couple hundred thousand dollars to achieve diversification. Thus, relatively higher portfolio sizes are necessary.
Time involved in research and management of portfolio. Due to the size of the market, the many different issuers and optionality considerations (calls/sinking funds), creating and maintaining a well-diversified individual bond portfolio can be more time intensive. The bond market is larger than the equity market!
Bond Funds
Bond funds can come in various forms, including fixed income open end funds, exchange traded funds, or even closed end funds. While the mechanics of each are a little different, at their core these investment vehicles allow the purchaser to participate in a larger pool of money and are managed by professional managers. This approach allows for diversification with a much smaller amount invested. The interest payments come in the form of dividends, usually paid monthly. There is no maturity date, and the portfolio will experience turnover at the manager’s discretion.
The key benefits to owning bond funds are:
Diversification with lower investment amount. By pooling many investors’ funds together, bond funds can achieve diversification for the smaller investor.
Professional management. As a part of the fees paid, professional management is obtained. This shifts the time intensive task of research and management to the institutional professional, who has discretion over portfolio management decisions.
The key downsides to bond funds are:
Fees. Funds charge ongoing fees based on assets under management. These can vary from small monthly or quarterly fees for core funds to higher fees for more active non-core bond funds. With individual bonds, there is usually a trading spread charged on the purchase or sale, but no other management fees involved. An important component to the overall fee structure is that an investor will pay a spread to trade bonds whether it is through the construction of an individual bond portfolio or through a portfolio manager trading securities inside of a bond fund. This fee cannot be sidestepped.
Net asset value (NAV) is unpredictable. NAV will rise and fall conversely with interest rate movements. No certainty as to what the NAV will be at a given point in the future. This is especially true in periods of high volatility where rates might be rising and there are asset flows out of any fixed income sub asset class.
Cost basis and taxes. Investor is a part of a pooled investment, and thus, has less control over the tax consequences of portfolio turnover. Cost basis is also more complicated to track than with individual bonds.
Individual Bonds versus Bond Funds: A Comparison
Bringing the pros and cons of each approach together, we can see key differences between utilizing individual bonds or bond funds. In deciding which is best for your client, financial circumstances and goals should drive your preference. Below is a chart comparing some of the key points.
In comparing the two approaches, it is important to understand the size of your overall portfolio, and correspondingly, the size of the fixed income portion of the portfolio based on asset allocation. If you do not have at least a couple hundred thousand to invest in your fixed income allocation for a client household, it will be difficult to achieve proper diversification with individual bonds. In this situation, finding a diversified bond fund will likely be more appropriate.
After this, it is important to assess financial planning goals and expectations to assist in evaluating which approach best aligns with your client’s needs.
Individual bonds have a more predictable value, maturity date, and can avoid market volatility and risk when held to maturity. This allows for better income planning (assuming no defaults). When planning to buy and hold, you can also avoid the ongoing portfolio fees that are contained in bond funds. Maturing bonds do not include any fees, but the reinvestment of maturing principal will involve analysis and a buy-side transaction to put the principal back to work with an individual portfolio. Another characteristic of this approach is the bonds can be customized to your individualistic needs.
An important factor to consider is the interest rate environment at any given time. Generally speaking, when interest rates rise, bond prices fall. When rates fall, bond prices rise. Interest rate moves will affect the investor in slightly different ways. With individual bonds, the investor can hold to maturity and receive their principal back regardless of the moves in interest rates. With bond funds, the NAV will adjust according to the rate environment at the time. Thus, the investor’s principal will be determined by the interest rate environment at the time they need to sell the fund.
During a rising interest rate environment, like we have seen recently, this difference becomes apparent. While the bond fund investor has no assurance their principal value will recover, the individual bond investor can rest assured they will receive their principal amount back at maturity (again, assuming no defaults). Additionally, the individual
bond investor can create a laddered bond portfolio, which will allow bonds to mature at pre-determined intervals so they can reinvest at higher interest rates while going through a rising rate cycle. This can help to increase economic portfolio yield expectations when in periods of rising rates.
Bond funds do not have the same predictability in value and are managed with an eye towards total return. Market risk is always inherent, and because there is no maturity date, it is difficult to predict what the value will be at a future date when you may need your money. Diversification is achieved with much smaller investment amounts, and by utilizing a professional manager, you can avoid the time and energy needed to research and maintain an individual bond portfolio.
Importantly, when utilizing a dedicated Fixed Income manager/trader from our PeachCap Fixed Income Desk, RIAs and other financial planners designing individual bond portfolios can be confident that they are employing all the necessary infrastructure to achieve professional fixed income management while not having to spend resources (both time and money) on this in house. By offloading this duty, a planner can focus on client-facing contact, foster more detailed conversations with clients and prospective new accounts, and offer a much higher level of portfolio customization.
Bottom Line
As with all investing, individual circumstances, goals, and objectives should drive the decision-making process. Choosing individual bonds or bond funds each come with their respective pros and cons. We encourage you to consult with one of our team members to determine which path is most appropriate for your circumstance. Sometimes it can be a combination of core, short-intermediate individual bonds, complimented by non-core bond funds in small allocation percentages for additional diversification. There is not a right or a wrong answer as to which approach one should take. It is more important to understand the differences between the two, so you can make the decision that best suits your client needs based on their financial plan.
The above summary of statistics/prices/quotes has been obtained from sources believed to be reliable but is not necessarily complete and cannot be guaranteed. The information and opinions herein are for general information and illustrative use only. This data is not meant to replace Adviser's portfolio management/performance reporting systems. Please consult Adviser performance reports for actual performance data. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sale of any security or as personalized investment advice. Past performance is no guarantee of future results. Market risk is a consideration if sold prior to maturity. May lose value. Not insured by any federal agency. Subject to availability and price change. Securities offered through PeachCap Securities, Inc., member FINRA, SIPC, MSRB registered.