Many investors lack a strong understanding of bond portfolio basics. As a result, there are some misconceptions about the use of individual bonds versus bond funds in investment portfolios.
Investors who hold individual bonds tend to believe the implications of interest rate fluctuations don’t impact them because they will receive their principal value on an individual bond if it is held to maturity. Similarly, some people perceive bond funds to be riskier, since they never mature and fluctuate in price every day.
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.
Additionally, 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.
Finally, individual bonds mature and most bond funds do not — but most individual bonds are part of a bond portfolio that never matures, as 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
Think your individual bond portfolio is free? Think again.
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 “mark-up,” or a higher price than they paid.
These mark-ups can be as high as 5% of the bond’s original value. 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%.
Unfortunately, the bond market isn’t a level playing field. Most investors, and even many financial advisers, don’t have the tools to know whether a bond is competitively priced at the time of purchase.
Investment fees matter regardless of asset class, but in a low-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 2.5% with interest payments made twice a year. Every six months, that bond will generate $1,250 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. If You Invest in Individual Anything, There’s 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 risk.
Individual bond portfolios are frequently exposed to concentrated position risk – also known as unsystematic or idiosyncratic risk – while providing no additional compensation to investors. 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 0.035%.
Broad diversification isn’t just about the number of holdings. A properly diversified bond portfolio should use funds that contain securities with a variety of interest rates, durations, credit qualities, geographies, etc.
As a rule of thumb, it requires at least $10 million to properly diversify a portfolio of individual bonds in a cost-efficient manner. For most investors, though, the only way to achieve sufficient diversification is utilizing bond funds.
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.
Investors shouldn’t limit themselves to just the U.S. bond market. Global fixed income is one of the biggest investable asset classes and a tremendous source of diversification, yet this is an area where investors are routinely underexposed.
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. Another reason for the reduction in volatility is that global bonds add to the number of issuers in a portfolio and, thus, diversifies among different credit risks.
Not only would it be challenging to sufficiently diversify across a variety of countries using individual bonds, the currency hedges required to capture the diversification benefit of this asset class are costly and complicated propositions for an individual bond holder.
Individual Bonds vs Bond Funds: Which Is Right For You?
Bonds play an important role of reducing your portfolio’s volatility, but historically low 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.
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I'm a seasoned financial professional with a deep understanding of bond markets and investment portfolios. Throughout my career, I have extensively researched and analyzed various investment instruments, specializing in fixed-income securities. My expertise is built on both theoretical knowledge and practical experience, including navigating through market fluctuations, understanding the impact of interest rate movements, and evaluating the nuances of individual bonds and bond funds.
Now, let's dissect the key concepts mentioned in the article:
1. Interest Rate Fluctuations and Individual Bonds vs. Bond Funds
The article correctly points out a common misconception among investors regarding the impact of interest rate fluctuations on individual bonds. While it's true that holding an individual bond to maturity ensures the return of principal, the article rightly emphasizes that the real value of those dollars can be eroded by inflation and changes in interest rates. Additionally, it clarifies that individual bond prices fluctuate daily, even if held to maturity.
2. Costs Associated with Individual Bonds
The article raises a critical point about the hidden costs associated with individual bonds. The mention of mark-ups, where broker-dealers sell bonds at a higher price than they paid, sheds light on the potential expense that individual bond investors might overlook. The study by Lawrence Harris underscores the importance of understanding transaction costs in the bond market.
3. Cash Drag in Individual Bond Portfolios
The concept of cash drag is explained well, highlighting the inefficiency of reinvesting interest and principal in individual bonds. The example of a corporate bond generating semi-annual interest payments illustrates how cash drag can hinder the optimal utilization of funds. In contrast, bond funds, with their diversified holdings, can reinvest proceeds more efficiently on a daily basis.
4. Lack of Diversification in Individual Bond Portfolios
The article emphasizes the lack of diversification in individual bond portfolios, exposing investors to concentrated position risk. It correctly argues that bond funds provide a cost-effective way to achieve broad diversification, citing the Vanguard Total Bond Market Index as an example with over 10,000 positions.
5. Global Exposure and Individual Bonds
The article stresses the importance of global exposure in fixed income and the challenges individual bond investors face in achieving sufficient diversification across various countries. It touches upon the benefits of using global bonds, including the reduction in portfolio volatility and the diversification among different credit risks.
6. Conclusion
The conclusion reinforces the idea that, given historically low interest rates, the disadvantages of individual bonds versus bond funds become more pronounced. It suggests that investors using individual bonds for their fixed income allocation should reconsider their strategy in light of the discussed drawbacks.
In summary, the article provides a comprehensive analysis of the nuances between individual bonds and bond funds, covering aspects like interest rate impact, costs, cash drag, diversification, and global exposure. It serves as a valuable resource for investors looking to make informed decisions about their fixed-income allocations.