Stocks

Bond Funds or Individual Bonds? What You Need To Know

Stocks

A common question we receive from clients has to do with bond strategies. Should we buy bond funds or build individual bond ladders? There are a few things to keep in mind when thinking the role of fixed income from a portfolio standpoint. As an investment advisor, we think about the investment objectives of the client, the risk preference, liquidity needs, time horizon, and tax sensitivities. At the same time, we must be able to balance these objectives with the operational constraints within our firm.

When thinking about investor objectives within fixed income, almost every investor is utilizing bonds to dampen the amount of overall risk in the portfolio. With this objective in mind, we need to either find available bond funds or build our own strategy that is targeting bonds that are the most uncorrelated with global equities. This would be very high quality government bonds that have shorter maturities. Once we extend into the corners of the market of lower credit quality or long-term maturities, the correlation with global equities goes up, which is the opposite of what we are trying to accomplish.

We also must understand how the liquidity needs and tax sensitivities impact the decision of how to build our bond allocation. High liquidity allows investors to not only access their money quickly, it also allows IFA’s portfolio and risk management department to rebalance a portfolio back to its target risk level in a timely manner. There is also the benefit of incurring lower costs due to the high liquidity associated with bond funds. Tax sensitivity describes how a fixed income allocation can be tailored depending on an investor’s personal tax situation. An investor who find themselves in the highest income and capital gains tax brackets could look to municipal bonds in order to accommodate the very high tax sensitivity.

This brings us to the main question: given all of these considerations, does it make sense to use bond funds or individual bonds? Let’s consider the pros and cons of each.

Individual bonds allow for more customization in terms of managing critical liabilities, creating custom cash flows, or targeting specific credit or term risk factors in the market. A public pension utilizes individual bonds to help meet legal obligations to their public employees in retirement. These are clearly defined liabilities that must be met. Certain investors may be looking for predictive cash flows each week, month, or quarter. Lastly, some investors may be looking for a certain combinatin of duration matching or targeting specific credity quality. Individual bond ladders can readily accommodate these types of investor objectives.

Considerations of using individual bonds include concentration risk and diversification, trading costs, and reinvestment risk. To ensure that investors are not exposed to certain idiosyncratic risks such as concentration in a certain company, industry, or state, it is important to be very well diversified. It is also crucial to understand that the total return from a fixed income strategy also includes the return on reinvested coupon payments. Since most bonds can only be bought in lots of $1,000, there is a chance that some coupon payments will be sitting in cash. Trading costs are also a major contributor in the decision of whether or not individual bonds make sense in an investor’s portfolio. There is a negative correlation between trade size and cost of trading (i.e. the larger the trade size the cheaper the cost of trading).  The chart below shows the trading costs associated with municipal bonds.

As you can see, trading in small lots (<$10,000) creates a cost of almost 2% of principal. Costs become more reasonable once we start trading in millions of dollars. In contrast, bonds funds are able to pool money across many investors, which create economies of scale for everyone. Although a particular investor may only have $10,000 in a bond fund, they receive the cost treatment as if they were trading $50 million, for example.

There is also the cost of maintaining individual bond ladders for investors who want to create custom cash flows or manage interest rate risk. The chart below shows the annual cost of maintaining a $1 Million bond ladder.

For example, a $ 1 Million bond ladder where the longest maturity bonds is 6 years and the expected holding period of the ladder in 10 years costs 0.20% per year in trading costs. This can be analogous to the expense ratio of a bond fund. Depending on how important the custom cash flow is to the investor, there are much cheaper bond fund options available for investment.

One of the more common situations that begs the need for individual bond ladders has to do with the tax exemption of municipal bonds where investors are not taxed (both federal and state) on the coupon payments made from municipal bonds as long as those bonds correspond to the investor’s state of residence (i.e. a California resident doesn’t pay taxes on municipal bonds issued in California). Muncipal bonds outside the investor's state of residence are only taxed at the state level, if applicable (for example, Texas does not have state income taxes). If a bond fund strategy doesn’t exist for a particular state (i.e. Delaware), does it make sense to go into the secondary bond market to build individual bonds ladders for that particular investor?

It is important to understand that in well functioning capital markets, including global bond markets, the taxable equivalent yield of a particular municipal bond already reflects the anticipated tax benefit. In other words, bond prices for municipal bonds have already been bidded up as to remove any tax-exempt arbitrage benefit an investor would receive relative to a taxable bond with identical duration and credit quality. If the taxable equivalent yield of a municipal bond happens to be higher than that of a taxable bond of identical duration, then this would reflect lower credit quality (higher risk of default). In the context of an entire portfolio, we believe investors get more “bang for their buck” by pursuing risk in the equity market versus the fixed income market. You can read more about historical premiums in Step 8 of IFA’s 12-Step Recovery Program for Active Investors.

The benefit of using bond funds includes the immediate investment of funds, daily liquidity, lower concentration risk, scale in terms of costs and research, flexibility in rebalancing, and more cost effectively pursue the credit and term premiums depending on the current term structure and credit spreads in the bonds market.

IFA’s Index Portfolios utilize 4 bond funds from Dimensional that target high quality shorter term global bonds in attempt to dampen the volatility in the portfolio as well as cost effectively diversify our client’s money while gaining the benefit of Dimensional’s ability to pursue higher sources of return within the bond market. While their practices may be replicated with an in-house bond trading desk, their many years of practice and research is much harder to replicate.

Unless there is a very specific liability that is legally required to be paid, almost all investors are better served by sticking with bond funds. This is due to the diversification, cost effectiveness, liquidity, and scale in terms of credit research of bond funds.