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Individual Bonds Vs. Bond Funds
I won’t pretend that it’s easy to sort through the mountain of available information arguing for or against bond funds relative to individual bonds. From my experience, I would say you should be skeptical of any article claiming that either of the two approaches is always the correct answer regardless of circumstances. In my opinion, a thorough analysis of the two choices yields a much more nuanced answer.
 
The Big Caveat
 
Before we get started, I should point out that I’m not talking about buying bonds through a broker during this discussion. If that’s your alternative to buying a bond fund, do your portfolio a big favor and go with a low-cost bond fund from DFA or Vanguard. The world of buying individual bonds through a broker is fraught with conflicts of interest, poor advice, undiversified portfolios and hidden costs. However, the analysis gets more interesting when you have the ability to buy individual bonds in a transparent, low-cost manner, which is what I’ll focus on from here.

Choosing Between Low-Cost Bond Funds and Individual Bonds
 
There are four parameters you should focus on when making the decision between bond funds and individual bonds:
  1. Diversification and default risk
  2. Cost
  3. Liquidity
  4. Tax circumstances

Diversification and Default Risk

A common theme throughout my analysis is paying for what you need but nothing more. Stock investors should be more than happy to pay a low expense ratio in return for the diversification a mutual fund provides. It helps to own a very large number of stocks to eliminate “company specific” risks like a product offering failing, a successful CEO having health problems or anything else that could cause a company to go bankrupt or have poor stock performance.

With high-quality bonds, however, diversification isn’t nearly as important. For example, if you own a U.S. Treasury bond, buying a CD doesn’t improve diversification, since the U.S. Treasury bond is broadly considered to be the highest-quality security in the world. In such markets, a strong argument can be made for owning the bonds individually, which saves the fund expense ratio. Saving even a modest fund expense ratio can generate sizable value over the long term as the savings compound.

Municipal bonds have slightly higher default risk than Treasury bonds and therefore require more diversification. Over the period 1970–2011, there were 71 defaults on Moody’s-rated municipal bonds compared to 261 corporate bond defaults in 2009 alone. So while it’s apparent that diversification is more important with municipal bonds than with U.S. Treasuries, diversification across issuers is easily achieved once your bond portfolio is $500,000 or more. Below those levels, you should strongly consider using a low-cost municipal bond fund instead of buying the bonds individually.

As we move down the credit scale, diversification becomes significantly more important. For example, I would say there’s almost no scenario in which an investor should buy individual investment-grade or high-yield corporate bonds instead of owning a low-cost fund.

Why? The probability of a single corporate bond defaulting is too high for anyone but very large institutional investors to achieve adequate diversification via individual bonds. Historically, investment-grade corporate bonds have defaulted 34 times more frequently than investment-grade municipals, and high-yield corporate bonds have defaulted more than 700 times more frequently than investment-grade municipals. This level of default risk requires the diversification that a low-cost fund can provide.

Cost

I often hear that the purchasing power of large institutional buyers like mutual funds leads to lower transactions costs than individual bond buyers incur. While it’s true that trading costs tend to decline for such large institutional buyers, yields are also typically lower for larger purchase sizes compared to smaller sizes. In effect, these large institutional buyers are paying for ease of trading. (As the old saying goes: “There’s no free lunch.”)

Investors who generally plan to hold bonds to maturity can potentially benefit by buying the smaller bond sizes that most institutional investors avoid, since these smaller bond sizes tend to have higher yields. (This is called the “odd lot” effect within the bond market.) That’s, of course, in addition to saving the fund expense ratio, leading to two significant advantages relative to a low-cost bond fund strategy.

Liquidity

Investors who have withdrawal needs that can’t be covered by stock fund dividends and principal and interest payments on bonds will likely need to keep some portion of their portfolio in bond funds. Since bond funds can be sold with minimal cost, they can serve a useful role when liquidity needs can’t be met by other sources. However, allocating the entirety of the bond portfolio to bond funds may mean paying for liquidity that isn’t needed. So, the bond portfolio needs to reflect your actual liquidity needs. Solely using individual bonds or only using bond funds can’t be the right approach for everyone.

Tax Circumstances

Tax circumstances vary by investor, now more than ever thanks to new income thresholds that trigger additional taxation like the Medicare surtax. Therefore, by definition, a bond fund can’t be managed tax efficiently for all taxable investors.

As one example, California residents may want to own some California municipal bonds due to their double tax-exempt status, while Missouri residents should probably minimize their exposure to California municipals since better risk-adjusted returns are likely available from other issuers. Such customization is easily accomplished with individual bonds but is virtually impossible to do with bond funds.

Reinvesting Coupon Interest

One other critique of individual bond portfolios is the potential inefficiency associated with reinvesting coupon payments. A diligent system for monitoring cash holdings and effective use of bond funds can help minimize this issue.

On most trading platforms, investors can access either no-transaction fee bond funds or bond funds with minimal transaction costs. Coupon payments can be invested in these funds periodically to keep cash holdings at a minimum. Further, for large individual bond portfolios, the interest payments are frequently large enough and regular enough that you can simply purchase individual bonds directly with those interest payments.

Conclusions

As I noted at the top of the post, there’s no one-size-fits-all approach to deciding between bond funds and individual bonds when individual bonds can be purchased in a transparent manner. The decision should reflect portfolio size, diversification needs and liquidity requirements and may end up leading to a mixture of both individual bonds and bond funds being the right solution.

Random Links and Commentary of the Week

Here’s one of the better blog posts I’ve read in some time on the likely modest effects of current monetary policy on economic growth.

Here’s some perspective on forward-looking real returns for a plain vanilla stock and bond portfolio quoting my co-author Antti Ilmanen.

Jared Kizer is the director of investment strategy for The BAM ALLIANCE. See our disclosures page for more information.

Comments

How do you buy bonds and avoid brokers?

Jared,

You say above "However, the analysis gets more interesting when you have the ability to buy individual bonds in a transparent, low-cost manner, which is what I’ll focus on from here."

How do you avoid brokers and buy bonds in such a manner?

wjdulmage@financial-pathways.com
at 3/21/2013 8:50 AM

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