As the Fed has increased rates dramatically, it has pushed interest rates up, causing some investors to ask if buying individual bonds is more efficient than a bond mutual fund or ETF. This thought process stems directly from the “principal at maturity” myth, which argues that bond funds will sell bonds at a loss when rates rise. In contrast, portfolios of individual bonds can be held to maturity and avoid losses. The truth is that the known maturity does not provide the safety it seems. There are many low-cost bond mutual funds and ETFs which are more advantageous for both individual and institutional investors. Funds are superior for four main reasons: significant diversification, lower transaction costs, higher liquidity, and professional management.
Individual Bonds are No Safer
The first assertion commonly made by advocates of individual bonds is that you cannot lose money if you hold the bond to maturity. This, of course, assumes there is no default and implies that the interest rate risk inherent in all bonds is avoided by holding a bond to maturity. There is an inverse relationship between bond prices and interest rates. Bond prices go down when interest rates go up, and vice versa. A 10-year bond yielding 4 percent will lose 8 percent of its value if interest rates rise to 5 percent, and its value will drop 15 percent if interest rates rise to 6 percent. The argument for individual bonds is that you will get 100 percent of the face value of the bond if you hold it to maturity. This is true, but is it advantageous? Holding a bond to maturity to avoid the loss resulting from rising interest rates does not avoid the loss.
Holding a bond paying below-market interest is just a different way to take the loss. All one achieves by holding the bond is to take a capital loss and spread it over the remaining life of the bond in the form of lower interest payments. As soon as interest rates move, the loss has occurred. The investor’s only decision is whether to take the loss in lower interest payments over time or as an immediate capital loss. For example, your neighbor just sold his house for less than you paid for your house. The fact that you are not selling your home doesn’t change the fact that your house has also declined in value, most likely.
Most Bond Mutual Funds are Too Expensive, But Not All
The second claim made by advocates of individual bonds is that bond mutual funds are too expensive. This is a valid complaint against many bond mutual funds. The average bond mutual fund in the Morningstar® database has an expense ratio of 1.02%, while some funds impose a front-end sales charge that could double the expenses. It makes no sense to buy a bond mutual fund with expenses like that. This type of mutual fund gives rise to the popular belief that bonds should be purchased outright, not in a bond mutual fund. However, the lowest cost quintile within the bond universe is an expense ratio of 0.42%. In comparison, ETF bond funds have an average expense ratio of just 0.40% due to their more efficient passive structure. In contrast, the fixed income funds in your portfolio with Resource Consulting Group have an average expense ratio in the 0.07% to 0.17% range. These funds cannot be dismissed so easily.
Institutional Bond Investors Get a Better Deal
Moreover, institutional investors, like a mutual fund company, enjoy much more favorable bond pricing. They buy for less and sell for more than retail bond investors. The bond market does not work like the stock market. Some people get different prices. The bond market is made up of dealers. These dealers buy and sell bonds like used car dealers buy and sell cars. They try to buy for as little as possible and sell for as much as possible. What they will pay for a bond depends on what they think they can sell it for.
A dealer may be willing to pay a fair price for a 1 million dollar round lot position for which he knows he has a buyer. On the other hand, a $100,000 position is generally considered an odd lot. A dealer will be interested in something other than such a small position and price it higher if selling to an investor or lower if buying from an investor.
Further complicating matters is the fact that brokers commonly price their commission into bonds. This makes it challenging to determine what you are truly paying for the bond and what you are paying in commission. Sometimes brokers bypass the dealer and buy and sell bonds in their own inventory. In that case, the broker may not even know what commission they are charging. It is all blended.
Specifically, between January 2019 and April 2021, the effective spread for transactions with a par value
between $25,001 and $100,000 averaged 56.4 basis points (bps), see chart, while transactions with a par value of over $1 million averaged 20.2 bps. This differential translates to lower total returns for clients unable to transact at scale. Additionally, large firms can get the broadest access to bonds in the primary market, so it’s not only about the size of the trade and lower costs but also what bonds one gets to purchase. This is especially important as there tends to be a drop-off in liquidity as time passes from issuance. Source: MSRB and Vanguard, intermediate term 5-10 year US corporate bond transactions from January 2019 – April 2021
Bond Mutual Funds & ETFs Provide Diversification and Ease of Management
The two principal advantages cited by advocates of individual bonds are less compelling on closer inspection than they seem at first glance. Holding a bond to maturity does not protect investors from the loss resulting from interest rate movements. There are many low-cost bond mutual funds where institutional pricing can offset some or all of the cost.
For most investors, the most important advantage of a bond mutual fund is diversification. While a $2 million portfolio of bonds might own 8 or 10 individual bonds, a bond mutual fund will own hundreds if not thousands of different bonds. This means any individual default will have minimal impact on the portfolio. Investors looking for the higher yields of corporate bonds or the tax benefits of tax-exempt bonds will benefit from this greater diversification. This is important even for Treasury bond investors as it diversifies reinvestment rate risk by constantly investing cash flows.
There are also strategies that are advantageous to bond investors. One of our managers is constantly investing in the steepest part of the yield curve, harvesting the maximum return over a given maturity range, a statistically proven way to increase returns without forecasting interest rates. For another example, the last year before a bond matures is usually the lowest return year. Institutional investors can increase returns by selling a bond before it matures. Retail investors will decrease returns by selling a bond before it matures because of higher spreads. Professional fund managers will use these and other strategies to maximize return based on the structure of interest rates and the shape of the yield curve without relying on a forecast of interest rates.
A final advantage is that bond funds are much more liquid. While the value of a bond fund will fluctuate with the market, a bond fund can be liquidated entirely at institutional pricing at any time. This is very important to many investors. This allows easy, cost-effective portfolio rebalancing. Moreover, bonds are often the safest portion of a portfolio. Therefore, investors will first look to the bond portion of their portfolio to meet a surprise cash need. In addition, many investors for whom tax-exempt bonds were appropriate during their working years will find taxable bonds better when they retire. They may want to convert their entire portfolio from municipal to taxable bonds on January 1 of the year their taxable income drops. Doing so would be prohibitively expensive for a portfolio of individual bonds but very inexpensive for a portfolio of bond mutual funds.
Bond Mutual Funds are Better for Most Investors
In summary, fixed income portfolios of less than $10 million should almost certainly be invested in bond mutual funds. Above $10 million, the merits of bond mutual funds versus individual bonds are open for debate – although even above $100 million, bond mutual funds have some benefits over individual bonds. There are 89 bond mutual funds in the Morningstar® database with minimums of $10 million or more. There are two bond funds with a minimum investment of $3 billion, three with a minimum of $750 million, and nine at $100-300 million each. This is evidence that many bond investors and institutions are investing massive sums in bond mutual funds. For most investors, accessing fixed income via low-cost active or passive funds is likely to provide better outcomes than the direct ownership of individual bonds—even with the hurdle of management fees.
PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Indices are not available for direct investment; therefore their performance does not reflect the expenses associated with the management of an actual portfolio. The index returns above assume reinvestment of all distributions. This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale.