Last week we talked about the role of bonds in your portfolio. We noted that, while bonds generate income and may generate capital gains (when interest rates decrease, the value of a bond will increase), the primary role of bonds in your portfolio is to dampen the portfolio\u2019s volatility (i.e. reduce the variability of its returns). When the stock market is temporarily bouncing around or, worse, dropping precipitously, bonds will serve as ballast in your portfolio and keep you upright.<\/p>\n
We left off asking whether investors should use individual bonds or bund funds in their portfolios.<\/p>\n
Let\u2019s first consider why an investor might want to use individual bonds. If you are funding a specific objective in the future and you want to be certain that the money will be there at that time, a bond can be an attractive tool. Recall that when you buy a bond you are loaning a sum of money to the issuer under contract terms that require the issuer to pay you that sum back at some agreed-upon date in the future (e.g. 5, 10 or even 30 years). In addition, along the way you will receive interest (or \u201ccoupon\u201d) payments to compensate you for the issuer\u2019s use of your money. If interest rates move up, causing the value of your bond to drop, you should not care all that much, because your intent was to fund some future obligation and, unless you sell the bond, you will not incur a loss. You will continue to receive your interest payments and, when the bond matures, you will get the principal you invested originally. This strategy is rather appealing to investors and has led to the creation of \u201czero coupon\u201d bonds that are bought at a deep discount (i.e. far less than the value at maturity) and include no interest payments during the life of the bond. So-called \u201czero\u2019s\u201d allow investors to lock in a future payment with a current investment.<\/p>\n
But unless you are an investor funding some time-certain future goal (e.g. college), bond funds are typically more attractive than individual bonds. For starters, it is not possible for most investors to achieve any meaningful diversification in the bond portion of their portfolio by investing in individual bonds. It would take tens of millions of dollars to invest in enough individual bonds to be properly diversified. Few retail investors have portfolios that large.<\/p>\n
Also, brokers typically charge small investors large \u201cmark-ups\u201d when trading bonds on their behalf. These mark-ups can be as high as 2.5% of the value of the bond. This mark-up is an immediate drag on investment performance. In contrast, there are no \u201cmark-ups\u201d for investors in bond funds.<\/p>\n
Most individual bonds trade \u201cover-the-counter\u201d and not on established exchanges. This means that the buyer and seller interact directly with each other and not through a trading exchange. Thus, the bond market is not public and transparent. Consequently, it is very difficult for a retail investor to know if the price being offered by a broker to buy or sell a bond is fair. However, bond ETFs (exchange-traded funds) are traded on an exchange which provides price transparency, while bond mutual funds are bought from and sold to the fund\u2019s manager at \u201cnet asset value\u201d.<\/p>\n
Individual bonds may or may not be liquid, meaning that they can be readily traded at a price close to fair value. Some bonds trade very infrequently. The trading costs for such illiquid bonds may be higher than those bonds for which there is a robust market. It can be very difficult for an individual investor to sell a bond that is illiquid. Bond ETFs are generally more liquid, while bond mutual funds can always be redeemed with the fund manager.<\/p>\n
Individual bonds typically pay their coupons twice a year. That can be problematic for investors seeking steady monthly income. Bond mutual funds typically pay interest monthly.<\/p>\n
So, to recap, we typically use bond ETFs and mutual funds for our clients\u2019 portfolios because they offer better diversification, more competitive pricing, better price transparency, greater liquidity and more frequent income distributions. <\/p>\n