Ladder

Q&A with IFA: Bond Funds vs. Individual Bonds

Ladder

Question: Should the bond portion of my portfolio be in bond funds or in a ladder of individual bonds?

Answer: Like many things with respect to investing, a case can be made for either side. Any proposed bond allocation decision is simply a trade-off among the objectives of low volatility, liquidity, expected return, income, inflation protection, and tax sensitivity. The primary advantage of using individual bonds is the ability to have full control over the timing of future cash flows. However, identical cash flow streams can be replicated with bond funds, using a combination of fund distributions and selling fund shares. Furthermore, the cash flow control achieved with individual bonds comes with costs that we consider unacceptable for most investors. For the purpose of this article, we are only considering taxable investors using municipal bonds. An argument commonly made for individual bonds is that there is only a one-time trading cost of buying the bond and no costs thereafter. However, as the bar chart below shows, trading costs for investors with less than $1 million to spend per bond can be substantial, and these costs are especially noteworthy in today’s low-yield environment. To put it in portfolio maintenance terms, for a $1 million ten-year ladder consisting of twenty bonds, the average annual trading cost is about 0.21% of the portfolio according to Dimensional Fund Advisors, very similar to a low-cost passive bond fund.

Regarding individual bonds, there is a widespread misconception that we have encountered many times which is that as long as an investor is willing to hold a bond to maturity, term or interest rate risk is irrelevant. An investor holding an individual bond takes the exact same hit to his market value in the event of an interest rate increase as an investor with a position in a fund that holds bonds of the same duration. In the event of an interest rate decrease, both face the same issue of reinvestment risk. Furthermore, the control over cash flows afforded by individual bonds can be illusory when investors are faced with the problem of reinvesting coupon payments and rebalancing their portfolio, especially when there is a large drop in equity prices. Finally, the best laid plans of clients and advisors are always subject to change, and a bond ladder that was constructed for a ten-year liability may be costly to restructure for a five-year liability.

One of our biggest concerns with individual bond portfolios is the lack of diversification which may increase the risk of loss of principal from defaults. While some observers dismiss default risk in highly-rated municipal bonds as virtually non-existent, we see the Detroit bankruptcy settlement1 where bondholders got between 34 and 74 cents on the dollar as a sobering reminder that the default risk is real. "Hopefully this will educate not only investors, but also political leaders,” said2 Richard Ciccarone, a municipal debt analyst and president of Merritt Research Services in Chicago. “You can’t treat municipal debt as a risk-free investment.” The Detroit bonds were originally issued with an investment grade rating. A few months ago, we published this article arguing that underfunded state and municipal pensions pose a true threat to muni bondholders which is not always adequately disclosed. A clear lesson from the Detroit bankruptcy is that pension obligations trump bond payments, but in fairness, pension payments were cut but not to the same degree as debt payments.

In prior articles, we have stated that taxable investors who have a strong preference for muni bonds (and who don’t have capacity for fixed income in tax-deferred accounts) should stick with low-cost funds managed by reputable companies such as Vanguard and Dimensional Fund Advisors. In looking at current bond yields of five-year high-grade muni bonds compared to corporate bonds, it appears to be a reasonable move for an investor in a 35% or higher tax bracket. This lines up with our expectation that in an efficient market, a tax-free asset is priced by taxable investors such that they are indifferent between it and a taxable asset of comparable risk.


1http://www.bloomberg.com/news/2014-11-10/detroit-leaves-legacy-of-tarnished-pledge-for-muni-bond-buyers.html

2http://www.bloomberg.com/news/2014-11-07/detroit-bankruptcy-taught-muni-investors-painful-lessons.html