Bonds vs. Bond Funds

Posted on: July 24, 2014 by Martin Curiel, CFA in Investments

Many investors prefer to hold individual bonds instead of bond mutual funds or ETFs. This results in lower diversification, higher risk, and usually higher fees. We recommend that clients use bond mutual funds and/or ETFs as the more efficient choice.

In late 2012, a family who is now a MYeCFO client met with an investment adviser from a different firm for a free consultation. The adviser noted that they had a large portion of their investments in bond mutual funds. He pointed out that if interest rates were to increase, the value of their bond funds would decline; there would be no guarantee that the principal value would ever be recovered. The adviser argued that with individual bonds that do not default and are held to maturity, any decline in principal value would be reversed. Unlike the bond funds, there would be no loss of principal. Using this logic, he proceeded to recommend that the family sell its bond mutual funds and use the proceeds to build a portfolio of individual bonds.

Although the adviser’s description of how bonds and bond mutual funds work is technically correct, his logic is badly flawed. For example, suppose the family decided to build a portfolio of individual bonds maturing in 2, 3, 5, 7, and 10 years. If interest rates were to increase, the overall value of this portfolio would fall. (Bond prices move in the opposite direction of interest rates.) It is true that, assuming that there are no defaults, the family would eventually receive 100% of the principal value at maturity. However, after two years, the family will have cash from the matured 2-year bond. At that time, the family will be able to reinvest in another individual bond at now higher interest rates. If rates keep increasing, the value of their individual bonds that have not matured will be lower, but this is counterbalanced by the fact that the new available funds will be reinvested at higher rates. This process repeats itself every couple of years: A bond matures, which makes cash available that then gets reinvested at a newly set interest rate.

Stepping back, one can clearly see that this process is identical to what happens inside a mutual fund. Conceivably, a mutual fund manager could also purchase bonds maturing in 2, 3, 5, 7, and 10 years. Over time, as the individual bonds mature, the manager purchases new bonds maturing in later years. The value of the mutual fund portfolio falls with an increase in interest rates, but the future yield increases to offset that loss.

The takeaway is that either portfolio should have a similar market value, similar yield, and similar return, if all investments are similar and everything else is equal. There is no advantage or arbitrage achieved simply by “letting the bonds mature.”

In the aforementioned example, the adviser recommended to the family a managed portfolio of individual bonds with an annual fee of 0.65%/year. He argued that this fee was lower than what the family would pay in bid-ask spreads if they bought the bonds without the manager. He did not point out, however, that there are bond ETFs with fees much lower than what the adviser was offering.

In our experience, there are three reasons why bond funds are generally better than a portfolio of individual bonds:

1)     Diversification: Bond funds typically hold more securities, so there is generally more diversification across sectors, maturities, and other risk factors. Any bond defaults have a small impact inside a fund, but could have a big impact for an investor who only holds a few bonds.

2)     Liquidity: Individual bonds are generally not very liquid, which means that there is a large bid-ask spread when an individual trades these securities. As the adviser mentioned to the family, a managed fund of individual bonds could achieve a tighter bid-ask spread compared to the family doing the trades themselves. However, a large ETF or bond index fund will generally have a far better cost structure than any other alternative.

3)     Management Fees: If one uses an adviser to build a portfolio of individual bonds, it is extremely likely that his/her management fees will be much higher than those charged by an ETF or bond mutual fund manger. In the example above, the adviser was proposing a fee of 0.65%, yet some bond ETFs charge as little as 0.08%. When one considers that long-term bond yields sit around 2-4% (gross of fees), a 0.57%/year difference makes a big impact. To summarize, the MYeCFO perspective and insight on this topic:  

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