Bond funds are superior to individual bonds for four distinct reasons.
Listen now and learn:
- The hidden costs in individual bonds
- The easy-win individual bonds miss out on
- How to transition from individual bonds to bond funds
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Show Notes
In this episode, we are comparing individual bonds to bond funds. In my mind, one of those options is clearly better than the other, but I recognize that many investors lack a good understanding of how bonds really work.
If you have a few minutes, you can quickly read up about what you need to know about bonds. If you prefer listening to reading, then take a few minutes to listen to Episode 18 of the show on this topic.
A solid understanding of how to measure return on your bond portfolio and how bond prices change when interest rates change gives a lot more context to the misconceptions about the use of individual bonds versus bond funds in a portfolio.
The most common misconception among investors holding individual bonds is that they often believe price fluctuations don’t impact their holdings if they hold the bond to maturity.
While it’s true that holding an individual bond to maturity will result in the return of principal if the bond issuer doesn’t default, those nominal dollars will be worth less with inflation and during periods of higher interest rates.
Plus the lack of price volatility in individual bonds is an illusion. Individual bond prices fluctuate every day, even if held to maturity, but you may not notice if the bond isn’t re-priced every day.
The other common concern I hear from investors owning individual bonds is that most bond funds do not mature — but most individual bonds are part of a bond portfolio that never mature either. Investors usually reinvest the proceeds of maturing bonds into new bonds.
In other words, a portfolio of individual bonds is actually a form of a bond fund, but with four distinct disadvantages:
1. Individual Bonds Often Mean Higher Costs
A lot of people think their individual bond portfolio is free.
The cost of an individual bond is hidden and very difficult to measure since it is baked into the purchase price and yield. Rather than charging investors a commission to purchase a bond, a broker-dealer sells you the bond at a “markup.”
These markups are kind of like the difference between the wholesale price for an item and the retail price in a store. The cost of the bond markups can have a big impact on the yield you earn.
A 2015 study published by Lawrence Harris, former chief economist at the Securities and Exchange Commission, estimated the average transaction costs for retail-size trades is 0.85%.
More recently, S&P Dow Jones Indices published data from 2020 in a paper titled, “Unveiling the Hidden Cost of Retail Bond Buying” on the transaction costs for investment-grade municipal bonds. In it, they find that bond purchases of $10,000 or less cost an average of 90 bps. Purchases between $10,000 and $25,000 cost an average of 71 bps. And purchases between $25,000 and $100,000 cost 61 bps.
Compare this to a total bond market index that costs as little as 3 bps.
And yet, investors with individual bonds always assume their bond portfolio is free. Ten years ago, it was extremely difficult to uncover the cost of an individual bond portfolio, so I understand why these costs come as a surprise to many retail investors. And it’s not exactly easy to discern today, but it is possible if you have the right tools.
Investment fees matter regardless of asset class, but in a lower-return area such as bonds, it is arguably more important. So even though you might think your individual bond portfolio is costless, it is typically far more expensive than owning a bond fund.
2. Individual Bonds Can Create Unnecessary Cash Drag in Your Portfolio
Cash drag is the opportunity cost of not being able to reinvest interest and principal on individual bonds in an efficient manner.
Let’s say you own a $100,000 corporate bond yielding 4% with interest payments made twice a year. Every six months, that bond will generate $2,000 in interest.
If this interest is supposed to be a part of your fixed income allocation, you won’t be able to purchase another individual bond in that small of an increment. As a result, you are likely to have the interest sit in cash earning next to nothing – hence the term “cash drag.”
A bond fund, on the other hand, holds thousands of bonds with different yields, maturities, and durations. This means that managers can reinvest bond proceeds into new bonds on a daily basis at current market rates.
This eliminates cash drag and allows bond funds to better benefit from fluctuating interest rates because they act as a daily dollar-cost-averaging mechanism.
This is particularly important in a rising interest rate environment, as bond fund managers are able to more efficiently reinvest proceeds from their bond portfolios into new bonds with higher rates of return.
3. Investing in Individual Bonds Creates a Lack of Diversification
Basic financial theory tells us that risk and return are related, which implies that investors should be compensated for taking additional risks.
Individual bond portfolios are exposed to unsystematic or idiosyncratic risk, but those risks don’t provide investors with any additional compensation. This risk could be easily avoided through the cheap diversification that bond funds provide.
For example, the Vanguard Total Bond Market Index (BND) holds over 10,000 positions with a rock-bottom expense ratio of 0.03%.
Broad diversification isn’t just about the number of holdings, though. A properly diversified bond portfolio should use funds that contain securities with a variety of interest rates, durations, credit qualities, geographies, etc.
For most of my career, I’ve felt that it requires at least $10 million to properly diversify a portfolio of individual bonds in a cost-efficient manner.
To be clear, you could get relatively well diversified using individual bonds within a Separately Managed Account (or SMA), but that is effectively a bond fund for one. If you want to learn more about SMAs, check out Episode 95: What Is Direct Indexing?
But if you’re going that route of owning a fund, it’s usually going to be more effective than a bond mutual fund or ETF.
4. Without Bond Funds, You Might Miss Out on Global Exposure
Global fixed income is one of the biggest investable asset classes and a tremendous source of diversification, but good luck having diversified global exposure using individual bonds.
Using global bonds with hedged currency exposure has historically provided a dramatic reduction in volatility. Each country’s yield curve is shaped differently. And the factors that impact change in yields are lowly correlated across countries. A global opportunity set also adds to the number of potential issuers to choose from, which helps diversify credit risks and seek out sources of higher expected returns.
With individual bonds, though, not only would it be challenging to sufficiently diversify across a variety of countries, but the currency hedges required to capture the diversification benefit of this asset class are costly and complicated propositions for an individual bondholder.
How to Transition From Individual Bonds to Bond Funds?
If you’ve been holding individual bonds your entire life, I get that owning a bond fund that doesn’t really ever mature and experiences daily price fluctuations can be a bit unnerving at first.
And in the conversations I’ve been having with new clients, there’s an added uncertainty when transitioning from those holdings into a bond fund because doing so requires the investor to realize a loss on a position.
This is why it’s important to understand the basics. Choosing not to sell your individual bonds at a loss means giving up years, if not decades, of higher income from investing in bonds at the current market rate. That difference in earnings plus compounding over time ought to be much greater than the loss you would realize to make the transition.
You see, long-term bond returns are driven far more by income and compounding on the reinvested income than price fluctuations. I have a wonderful chart about this in our quarterly client market webinar that I’ll see if I can extract from the show notes. If that doesn’t work, then I’ll insert a link to the full webinar at thelongterminvestor.com
Bonds play an important role in reducing your portfolio’s volatility, but today’s higher interest rates make the disadvantages of individual bonds versus bond funds even more prevalent. Investors using individual bonds for their fixed income allocation would be well served to reconsider their outdated strategy.
Resources:
- What you need to know about bonds
- Episode 18: What You Need To Know About Bonds
- Unveiling the Hidden Cost of Retail Bond Buying by S&P Dow Jones Indices
- Episode 95: What Is Direct Indexing?
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Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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