When and Why to Invest in Bond Funds or Individual Bonds

When and Why to Invest in Bond Funds or Individual Bonds

Fixed income represents a major building block of diversified investment portfolios.   It generally serves to reduce overall risk in a portfolio and provide a stable income stream to investors.  This piece will explore:

• What are bonds, bond funds, and bond portfolios.
• The differences between using funds and portfolios of bonds.
• The risks of bond funds and bond portfolios.
• The difficulty for individual investors to buy and sell bonds at fair prices.

There generally isn’t a one-size-fits-all solution for using bonds in a portfolio.  Instead, we recommend utilizing the most efficient selection for different parts of the portfolio.

What is a bond?

• A bond is a debt security issued to raise money from investors willing to lend money to the issuer for a fixed period.
• Bond issuers are frequently governments, municipalities, or corporations.
• The income from municipal bonds is usually tax-exempt to the holder
• The most common bond that people enter is a mortgage on their home.  These are also packaged into investment securities called “mortgage-backed securities”.
• Bonds generally carry a fixed coupon for a fixed time period (commonly referred to as their maturity date).
• Some types of bonds carry variable, floating rate coupons, or can be called (redeemed) by the issuer early under certain conditions.
• In the United States, U.S. Treasury securities are considered the risk-free bonds to which other securities are compared.
• Common risks of bonds include interest rate risk and credit risk.
• A bond’s duration measures its sensitivity to changes in interest rates.   Longer maturity bonds usually have higher durations than shorter maturity bonds.  In general, when interest rates rise, bond prices fall.  Conversely, bond prices rise when interest rates fall.  The greater the duration of a bond, the more sensitive its price will be to interest rate changes.
• Credit risk measures the likelihood that a bond will default on its interest or final principal payments.  Generally, the lower a bond’s credit rating, the more the issuer has to pay to borrow money. The premium a borrower has to pay over Treasuries is called its credit spread.
• More information on bonds can be found at investor.gov.
  

What is a bond fund?

• A bond fund is an investment vehicle that pools capital from many investors to invest in individual bonds.
• Here we refer to both open-end mutual funds and ETFs (exchange-traded funds) for simplicity.  The main difference is that open-end mutual funds trade at the close of business at a single Net Asset Value (NAV).   ETFs trade throughout the day while markets are open.
• Funds can be either passively managed, following an index, or actively managed, buying securities with a view to beating a benchmark index.
• Bond indices track the performance of broad groups of bonds.  Common indices include the Bloomberg U.S. Aggregate (which includes U.S. Treasuries, corporate, and mortgage-backed bonds), the Bloomberg Municipal Bond, the Bloomberg U.S. Corporate, and the Bloomberg U.S. Corporate High Yield.
• Bond funds can own securities that are harder for individual investors to buy directly in a diversified manner, such as mortgages or high-yield bonds.
• Bond funds can provide broad diversification for smaller investment amounts than buying individual bonds.

What is a bond portfolio?

• A portfolio of bonds can be constructed with individual bonds to create a steady income stream over time.  The portfolios are often called a Separately Managed Account (SMA).
• SMAs can be constructed with a targeted average duration, credit risk, and types of securities.
• Common portfolios include U.S. Treasuries, municipal bonds, and corporate bonds.
• When securities mature, bonds can be reinvested or used elsewhere in an investor’s portfolio.
  

What are the differences between a bond fund and a bond portfolio?

• Some types of fixed income lend themselves naturally to funds – mortgage securities, high yield bonds, and other types of less liquid securities, where a diversified portfolio makes sense.
• The duration of an index fund generally remains the same over time; in contrast, the duration of an individual bond decreases over time.  
• If you buy a 5-year bond, in five years it will mature and you will receive your principal back, but a bond fund will still have the same 5-year average maturity and the same interest rate exposure throughout the whole time you own it.  In a period of rising interest rates, this can lead to losses of principal for fund investors.
• Bonds or SMAs can be used to match investment assets with future spending liabilities.
• Bond funds can be used to target a desired type of bond, duration, or credit exposure in a portfolio, and can be easily bought or sold to make portfolio changes.

What are the risks of owning bond funds versus bond portfolios?

• Whether you own a bond fund, or individual bonds in a portfolio, you are exposed to the credit of the underlying issuers.   Bond SMAs generally own fewer names than funds do.  If one issuer fails to pay its interest or principal, it can have an outsized effect relative to a bond fund.
• On the other hand, you don’t always know what you own in a bond fund.   This can lead to unexpected performance in times of crisis if the fund owns particularly hard-hit bonds.
• Bond funds can also be affected by the actions of other holders.  If a fund has redemptions which cause the fund to sell its bonds, this can affect the holdings of the remaining shareholders of the fund.  
• In any case owning actively managed funds is never a guarantee of beating an index. Active managers often have a hard time outperforming their benchmark, net of their management fees.

How easy is it to buy and sell bonds?

• Stocks are relatively straightforward to buy and sell.  They trade on centralized exchanges, such as the NYSE or Nasdaq, that consolidate the best bids and offers for each stock.  According to Wilshire Advisors, its Wilshire 5000 Total Market Index has only 3500 stocks in it.
• The bond market has many more securities.  The municipal market alone has over 55,000 issuers with over 1.1 million bonds according to data from SIFMA.
• There are no centralized exchanges for bond trading.  As a result, they can trade infrequently, and fair pricing on trades can be difficult to achieve.  Pricing can be opaque for all but the most traded securities, such as U.S. Treasuries.
• Individual investors are at a severe disadvantage compared to institutional investors when trying to buy or sell securities at fair prices.
• As a result, we rely heavily on institutional investment management firms for the mutual funds and SMAs that we use for our clients.  Institutional managers have a fiduciary obligation to their clients to seek the best execution prices for their clients.
  

Bringing it all together

• There is not a one-size-fits-all solution for fixed income investing in our clients’ portfolios.
• It is important to understand your goal for investing in fixed income: is it for income and stability in an overall diversified portfolio, is to buy bonds to fund future liabilities, or is it to target specific credit or duration characteristics in your portfolio?
• Using the best type of implementation vehicle for specific parts of the bond portfolios is important.  For example, a core SMA of high-quality bonds can be complemented by mutual funds to invest in high yield securities.
  

Reach out to your Farther advisor if you would like to speak further about the role of bonds in your portfolio and whether bond funds or portfolios make the most sense for your portfolio.

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