Individual Bonds vs Bond Funds (EP.97)

0:28We all need to make smart decisions with our money. In my mind, one of those options is clearly better than the other, but I also recognize that many investors lack a good understanding of how bonds really work. So I'm going to link to two resources in the show notes at thelongterminvestor.com. The first is a blog post called What You Need to Know About Bonds that I published about a year ago. And I think the visuals on a topic like this are particularly helpful, but if you're not near a computer right now and you want to brush up on the basics from your phone, then you can scroll down to episode 18, which is also called What You Need to Know About Bonds.

1:06In my opinion, if you have a sound understanding of how to measure return on your bond portfolio and how bond prices change when interest rates change, that gives a lot more context to the misconceptions about the use of individual bonds versus bond funds in a portfolio. The most common of which is that investors who hold individual bonds tend to believe that price fluctuations don't impact their holdings as long as they hold the bond to maturity. And while it's true that holding an individual bond to maturity will result in the return of principal if the bond issuer doesn't default, those nominal dollars will be worth less with inflation and during periods of higher interest rates.

1:50In addition, the lack of price volatility in individual bonds is really just an illusion. Individual bond prices also fluctuate every day, even if held to maturity. You just may not notice if the bond isn't repriced every day. The other common concern I hear from investors owning individual bonds is that most bond funds don't ever mature. But here's the thing. Most individual bonds are part of a bond portfolio that never matures either. Because investors usually reinvest the proceeds of maturing bonds into new bonds. So, in my mind, a portfolio of individual bonds is actually a form of a bond fund, but with four distinct disadvantages.

2:35The first is that individual bonds often mean higher costs. A lot of people think their individual bond portfolio is free, but the cost of an individual bond is hidden and very difficult to measure since it's baked into the purchase price and yield. Rather than charging investors a commission to purchase a bond, a broker-dealer sells you the bond at a markup. These markups, they're kind of like the difference between the wholesale price for an item and the retail price in a store. And the cost of the bond markets can have a really large impact on the yield you earn. A 2015 study published by Lawrence Harris, former chief economist at the SEC, estimated the average transaction costs for retail-sized trades on a bond market is 0.85%, or 85 basis points.

3:28More recently, S &P Dow Jones Indices published data from 2020 in a paper titled Unveiling the Hidden Cost of Retail Bond Buying on the Transaction Costs for Investment-Grade Municipal Bonds. In it, they find that bond purchases of$10 ,000 or less cost an average of 90 basis points, or 0.90%. Purchases between$10 ,000 and$25 ,000 cost an average of 71 basis points. And purchases between$25 ,000 and$100 ,000 averaged a cost of 61 basis points. Now, compare this to a total bond market index that costs as little as 3 basis points, or 0.03%. And yet, investors with individual bonds always assume their bond portfolio is free.

4:2010 years ago, it was extremely difficult to uncover the cost of an individual bond portfolio, so I understand why these costs come as a surprise to many retail investors. And it's not exactly easy to discern today, but it is possible if you have the right tools. Look, investment fees matter regardless of asset class, but in a lower return area such as bonds, it's arguably even more important. So even though you might think your individual bond portfolio is costless, it is typically far more expensive than owning a bond fund. The second of the four distinct disadvantages is that individual bonds can create unnecessary cash drag in your portfolio.

5:07Cash drag is the opportunity cost of not being able to reinvest interest in principle on individual bonds in an efficient manner. So let's say you own a$100 ,000 corporate bond yielding 4 % with interest payments made twice a year. So every six months, that bond will generate$2 ,000 in interest. If this interest is supposed to be part of your fixed income allocation, you won't be able to purchase another individual bond in that small of an increment. And as a result, you're likely to have the interest sit in cash earning next to nothing, hence the term cash drag. Now, a bond fund, on the other hand, it holds sometimes thousands of bonds with different yields, maturities, and durations.

5:53and this means that managers can reinvest bond proceeds into new bonds on a daily basis at current market rates. Not only does this eliminate cash drag, but it also allows bond funds to better benefit from fluctuating interest rates because they act as daily dollar-cost averaging mechanisms. This is particularly important in a rising interest rate environment as bond managers are able to more efficiently reinvest proceeds from their bond portfolios into new bonds with higher rates of return. The third disadvantage of individual bonds is that investing in individual securities of any kind always creates a lack of diversification.

6:35Basic financial theory tells us that risk and return are related, which implies that investors should be compensated for taking additional risk. But individual bond portfolios are exposed to unsystematic or idiosyncratic risk, which are risks that don't provide investors with any additional compensation. And yet, this risk could easily be avoided through the cheap diversification that bond funds provide. For example, the Vanguard Total Bond Market Index holds over 10 ,000 positions with a rock-bottom expense ratio of 0.03%. Now, broad diversification isn't just about number of holdings. A properly diversified bond portfolio should use funds that contain securities with a variety of interest rates, durations, credit qualities, geographies, etc.

7:26I've generally felt over the course of my career that it requires about$10 million to properly diversify a portfolio of individual bonds in a cost-efficient manner. And to be clear, you can get a relatively well-diversified individual bond portfolio through a separately managed account or an SMA, but that is effectively a bond fund for one. And if you don't know what an SMA is, you can check out episode 95 titled, What is Direct Indexing? to learn a little bit more about those strategies. But if you're going to go that route of owning a fund, it's usually going to be more cost-effective to own a bond mutual fund or ETF.

8:06The fourth disadvantage of individual bonds is that without bond funds, you might miss out on global exposure. Global fixed income is one of the biggest investable asset classes and a tremendous source of diversification. But good luck having diversified global exposure if you're using individual bonds. Global bonds with hedged currency exposure has historically provided a dramatic reduction in volatility. And I realize that having an understanding of bond basics might help a bit in understanding this point, but at its simplest level, every country's yield curve is shaped differently. And the factors that impact change in yields are lowly correlated across countries.

8:51And plus, when you think about a global opportunity set versus just an all-U.S. portfolio, the global opportunity set adds to the number of potential issuers to choose from, which helps diversify credit risks, but also helps you seek out sources of higher expected returns. With individual bonds, though, not only would it be challenging to sufficiently diversify across a variety of countries, but the currency hedges required to capture the diversification benefit of this asset class are both costly and complicated propositions for an individual bondholder. So, if I've convinced you and you're thinking, how can I transition from individual bonds to bond funds?

9:35Well, look, I get that owning a bond fund that doesn't really ever mature and experiences daily price fluctuations can be a bit unnerving at first. And in the conversations I've been having with new clients, there's an added uncertainty when it comes from transitioning those old holdings into a bond fund because doing so requires the investor typically realize a loss on the position. And this is why it's so important to understand the basics. Because choosing not to sell your individual bonds at a loss means giving up years, if not decades, of higher income from investing in bonds at the current market rate.

10:15Now, that difference in earnings plus compounding over time ought to be much greater than the loss you'd realize to make that transition. You see, long-term bond returns are driven far more by income and compounding on the reinvested income than price fluctuations. And I have a wonderful chart about this in our quarterly client market webinar that I'll see if I can extract from the video to include in the show notes. And if that doesn't work, I'll just insert a link to the full webinar at thelongterminvestor.com. Bonds play an important role of reducing your portfolio's volatility, but today's higher interest rates make the disadvantages of individual bonds versus bond funds even more prevalent.

10:58Investors using individual bonds for their fixed income allocation would be well served to reconsider their outdated strategy. As always, thanks for listening and until next time to long term investing.

11:16Thanks for listening to the long term investor podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions and the securities discussed in this podcast.