Individual Bonds vs Bond Funds

Stocks & Bonds

 Peter Lazaroff By: Peter Lazaroff

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.

Many individual bondholders 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.

It is true that holding an individual bond to maturity will result in the return of principal – assuming the bond issuer doesn’t default – but 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.

It is also true that individual bonds mature and most bond funds do not. However, 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. Higher costs

So, you 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. A broker makes money selling a bond to you at a “mark up,” or a higher price than they paid. Unfortunately, the bond market isn’t a level playing field because most investors (and 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. If you are paying more than 0.50% in annual expenses for an individual bond portfolio, you are paying too much. Unfortunately a recent study published by Lawrence Harris, former chief economist at the Securities and Exchange Commission, estimates that individual investors paid 0.77% to buy corporate bonds.

2. Cash drag

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. Since you can’t buy a bond in that small of an increment, you are likely to deposit the cash in a bank and earn next to nothing. Cash drag is the opportunity cost of not being able to reinvest interest and principal on individual bonds in an efficient manner.

A bond fund, on the other hand, holds thousands of bonds with different yields, maturities and durations. This means that managers are able to reinvest bond proceeds on a daily basis into new bonds at current market rates. Not only does this eliminate cash drag, but it also allows bond funds to better benefit from fluctuating interest rates as it acts as a daily dollar-cost-averaging mechanism.

This is important because, contrary to popular belief, rising rates are a good thing for long-term investors. Although rising interest rates are a good thing for all bond investors, it is the bond funds that appreciably benefit from rising rates as they are more efficiently able to reinvest proceeds.

3. 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 – which provides 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 17,000 positions with a rock bottom expense ratio of 0.07%.

Broad diversification isn’t just about 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 general rule of thumb, it requires at least $10 million to properly manage a portfolio of individual bonds in a cost efficient, diversified manner.

4. No global exposure

Global fixed income is the biggest investable asset class and a tremendous source of diversification, but good luck having diversified global exposure using individual bonds.

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Peter Lazaroff, Chief Investment Officer, first took an interest in investing when his grandmother gave him a single share of Nike stock for his 13th birthday. Today, nearly 20 years later, his investment insights are highly sought after by local and national media. More »