Clients and prospective clients often ask why we use bond mutual funds rather than individual bonds. The case for individual bonds is often stated as follows: “I can just buy actual bonds and hold them to maturity, so I know exactly what I’m getting and don’t have to worry about losing money.” Investors may also be reluctant to sell individual bonds if the bonds in question have a high interest rate (or coupon) attached to them. They ask, “Why would I sell my five-year, six-percent bond if current rates on five-year bonds are less than two percent?”
First, individual bonds are priced and trade intra-day similar to stocks. Market participants price bonds along two primary risk factors – credit risk and interest-rate risk. Credit risk is simply the risk that the bond will default, and bonds with higher credit risk should offer a higher interest payment. Interest rate risk, measured by a bond’s duration, refers to the inverse relationship between changes in interest rates and bond prices. As interest rates fall, bond prices rise and vice versa.
Today, many investors seem reluctant to sell individual bonds bought years ago when rates were much higher than the historic low levels of today. But many fail to realize that the current price of these bonds have appreciated in value to compensate investors should they wish to sell prior to maturity. Mathematically, the higher rate bond should be priced such that the investor is indifferent between holding the bond to maturity and selling the bond and immediately reinvesting in a lower-rate bond. Therefore, the decision centers on whether or not to recognize the return in the form of a capital gain today or income in the future.
Individual Bond Myths
Just because an investor owns an individual bond and plans to hold it until maturity does not mean that its value doesn’t fluctuate, nor does it mean that value can’t be lost – all bonds move in response to daily changes in interest rates, credit conditions, and a host of other variables. A bond fund with the same duration and credit quality as an individual bond will generally have similar volatility characteristics as the bond itself – the main difference is the concentration risk associated with owning a bond from a single issuer.
We understand the appeal of owning a bond to maturity, since a bond owner knows the value he or she will receive at the end of the period, while a fund owner does not. But the perceived safety is merely a function of ignoring the price fluctuations along the way. Because bond mutual funds don’t have a finite time horizon, more attention is given to the daily pricing of mutual funds than to individual bonds.
The Case for Bond Funds
One of the primary benefits of using mutual funds in lieu of individual bond holdings is the ease and cost with which a fund can be sold. With one simple trade the bond allocation can be adjusted to precision. This is more challenging with a portfolio of individual bonds, as investors are forced to trade in sizes unique to the bond issuance.
The collective buying power of a bond fund conveys a significant cost advantage over that faced by individual investors. Bid-ask spreads, the difference in price an investor receives when selling a bond and what he or she pays to buy a bond, are the hidden cost of individual bond holdings and often represent a source from which brokerage firms profit at the expense of their retail clients. Experienced bond managers can offer significant value simply through the scale with which they operate.
Many diversified bond funds will own bonds of different maturities, credit qualities, sectors or even countries. This level of diversification is often impossible to achieve with individual bonds. Additionally, interest generated by the bonds in the mutual fund is constantly being reinvested, while interest generated by individually held bonds must accumulate before reaching a level sufficient for additional bond purchases.
We believe that individual investors would be better served by focusing on management style (passive versus active) and the risk attributes of their bond holdings rather than the investment vehicle used to deliver exposure to fixed-income. While possible that an individual investor’s portfolio is sizeable enough to achieve adequate diversification with individual bond holdings, our view is that the benefits of passively managed bond funds outweigh the costs.