When it comes to investing in bonds, most of us have two options – we can buy bond funds or we can buy individual bonds. There are advantages and disadvantages to each approach and investors should evaluate which is right for them. In my experience, however, people often highly value the greater control that comes with owning individual bonds, but undervalue the benefits of lower cost and wider diversification (or “aging”) of a bond fund.
First, it is important to point out that both bond funds (including ETFs) and individual bonds fluctuate in value during their life – it’s just that a bond fund has more transparent pricing that is valued daily. Whether they are held directly or as part of a fund, changes in interest rates, credit risk, and inflation expectations result in variation in bond values even though investment-grade bonds typically pay full par value at maturity.
An example might help to illustrate this illusion of “control” over the value of an individual bond. If you bought $10,000 par value of a new 10-year Walmart Bond with 3% coupon priced at par, and the yield on this bond subsequently goes up to 4%, it is quite possible that this position will now be worth only $9,300 (a drop of around 7% assuming a 7-year duration). This same 7% drop on a bond fund investment would appear more noticeable because you can observe the daily fund returns. That’s not to say that holding individual bonds doesn’t give you more control over when to sell certain bonds, but the point is you do not have any more control over the market forces that impact the value of bonds at any given point in time. The control over holding individual bonds to maturity may be valuable in certain instances for people with a very specific time frame for their investments, but for long-term investors this becomes much less relevant.
What are the disadvantages of building an individual bond portfolio? As a former institutional bond portfolio manager and trader for over 20 years, I can tell you from first -hand experience that investing in individual bonds is harder than you might think. There are a number of things to consider, including:
- The ability and interest to research all the characteristics of the bonds (fixed vs floating, callable, coupon rate, tax consequences, etc.)
- The ability and interest to research the companies or governments issuing the bonds (credit risk and rating, potential for mergers & acquisitions, etc.)
- How to trade the bonds you want
- Determining if the price is fair
- Creating a diversified portfolio
- Ongoing monitoring of each bond and issuer
- Reinvestment of coupon payments
- Evaluation of corporate actions
Speaking from experience, it is very difficult to build a well-diversified portfolio and it takes a long time to do so. Even for a seasoned veteran like myself, it would take many weeks to build a diversified portfolio. This was particularly true for smaller portfolios. For example, a portfolio with less than $100 million at inception would be considered on the smaller side and it would be hard to find a sufficient number of bonds at a reasonable price to create enough diversification. Many shops have a small army of people dedicated to doing just that. If you want more evidence of this, look at the performance of your favorite bond fund or ETF for the first few weeks. In most cases, these funds have more volatility and lower returns than larger, more mature, “aged” funds.
Further, while there is an enormous amount of price information available for trading stocks, individual bonds tend to trade much less frequently. It is quite difficult to know the right price of an individual bond, and this lack of transparency can lead you to overpay. In the same way that car dealerships buy and sell cars at better prices than individuals, bond funds buy and sell bonds at better prices than individual investors. This difference can be significant, and almost certainly will result in lower returns for an individual bond portfolio as compared to a bond fund over the long term. Taking a snapshot of some typical corporate bond prices at a point in time demonstrates this point (See table below).
The retail premium in many cases is more than what you would pay in annual fees to own a bond fund (which can be as low as .03%). If you pay 30 bps (.30%) more for bonds than an institutional investor, that’s the equivalent of 10 years’ worth of fees on the Aggregate Bond ETF. Also, it is important to note that the above retail prices are valid on average for lot sizes of 5,000 to 10,000. Therefore, to build a diversified portfolio of government and corporate bonds of at least 30 bonds, you would need to invest at a minimum $150,000 to $300,000 to build your bond portfolio. Also, many investors find the task of investing in individual bonds a chore and will look to hire a professional to do the work for them, resulting in even more/higher costs.
From a tax perspective, investments in bonds and bond funds (especially ETFs) are quite similar. In either case, taxes will be due from periodic coupon payments. Similarly, capital gains or losses can be realized for bonds or bond funds since both are subject to price fluctuations (as discussed above). Funds may buy or sell more often than an individual portfolio, but the funds and ETFs we use have historically had extremely small capital gains distributions.
At the end of the day, investors should do whatever they need to do to meet their goals and sleep soundly at night. Maybe individual bonds can give some people the peace of mind they need, but there are a lot of misconceptions about the differences between individual bonds and bond funds. Investing in individual bonds does not shelter you from price risk, and while it does gives you control over security specific decisions, that control comes at a cost.