One of our clients recently asked a great question. Is it better to buy individual bonds or bond funds?
The old school consensus was that individual bonds were better, hands down.
Today, that couldn’t be further from the truth. Here’s why.
1). Bond funds and ETFs (exchange traded funds) are more marketable and easier to trade.
Prior to the 2008 Great Recession, many brokers made a market in bonds and bought and sold throughout the day for their own account. Since then, liquidity in the market to buy and sell individual bonds has dried up.
Fewer middlemen are now in the market to buy bonds, and bids (what brokers are willing to pay you) can be laughably low. In times of market stress, like the 2008 financial crisis, you might find that no one wants to buy your bond, which is a problem if you need to raise money.
Moral of the story: trying to sell an individual bond can often be like selling the proverbial white elephant at a garage sale. On the other hand, bond funds or ETFs (exchange traded funds) can be sold instantly by pushing a button on the trading screen.
2). Bond funds and ETFs can actually be cheaper.
Individual bond trades are padded with high markups – extra money to the broker – that you don’t even see.
“Some financial advisers suggest mom-and-pop investors stay away from buying individual bonds, because even small markups can eat up the returns on low-yield securities, and those fees can be hard to identify,” said a recent expose in the Wall Street Journal.
A Standard & Poor’s study of muni bond markups found that the costs can really add up. You should “expect to pay about 1.62% in markup on your munis. If you buy a muni bond with a face value of $50,000, you’ll pay about $810. You’d pay the same if you sold the bond before it matures. In today’s low-rate environment, that’s about half a year’s interest.”
Echoes Morningstar: “Transaction costs are high in the bond market and the large scale of bond funds helps to reduce expenses.”
3). Bond funds and individual bonds respond identically to rising rates.
Investors think if they hold individual bonds to maturity, they don’t lose money. Wrong. They do lose money (the money they lose is the higher interest they could be earning on a newer bond), but don’t perceive it because they don’t sell the bond. It just comes down to simple math.
Our recent blog article, using new research from Morningstar, showed that in a rising rate environment, individual bonds and bond funds have identical returns (link to our blog story here: “Myth Buster: Morningstar Says Individual Bonds, Funds Equally Affected By Rising Rates“).
Here’s another take on the topic from financial columnist Jonathan Clements:
“With great regularity, I receive emails from readers who insist that individual bonds are the better investment. Their argument: If interest rates go up, bond-fund investors lose money. But if you own individual bonds, you can hold them to maturity and get your money back.”
“The irrepressible Cliff Asness, managing principal of AQR Capital Management in Greenwich, Conn., took issue with this contention in an article last year for the Financial Analysts Journal. “Bond funds are just portfolios of bonds marked to market every day,” he wrote. “How can they be worse than the sum of what they own?”
4). Bond funds give you better diversification and expert selection.
Let’s face it. The bond market is vast (twice as large as the world equity market) with over $93 trillion worth of bonds outstanding. There are thousands of bond issuers, and thousands of issues, each with different terms, rates, maturities and financial soundness. Want a bond issued by General Electric? There are reportedly 500 different bond issues to pick from, and that’s just one company. Do you really have the time, and expertise, to plow through that enormous marketplace to pick the bond that’s right for you?
That’s why most individual investors use bond funds in place of individual bonds. Bond funds can help you diversify across maturities, geographic areas, and sectors, and use expert research to avoid issuers in financial distress.
To diversify properly with individual bonds, it takes an awfully big portfolio. “Even if I have $5 million to buy municipal bonds, I really can’t diversify enough by buying individual bonds,” said financial advisor Allan Roth, interviewed for a Wall Street Journal article on municipal bonds. “And if I have $500,000, then I really can’t diversify.”