There are two different schools of thought when it comes to the fixed income holdings in a portfolio; one is to invest in a portfolio of individual bonds, while the other is to gain exposure through investing in bond mutual funds. While there are positives and negatives to each strategy, we recommend investing in fixed income mutual funds and exchange traded funds (ETFs) in your portfolio as the preferred method to gain exposure to bonds for several reasons.
Bond funds provide for greater diversification than could practically be achieved through owning individual securities. With more assets in a fund it can invest in more types of bonds, or more types of certain issuers, credit qualities, maturities, and characteristics which reduces the non systemic risk of a portfolio. This occurs to a greater degree than in a separately managed individual bond portfolio. It allows a fund to spread the risk of less credit worthy issuers across a range of issues. A Lehman Brothers study suggested that owning a portfolio of 100 bonds would constitute a well diversified portfolio. Having this number of securities in a separately managed portfolio of individual bonds is unlikely, would require a significant amount of research, and would require constant supervision. Thus, it is not as likely the account would be as well diversified.
One can create a fully diversified bond portfolio with one purchase using a bond fund, whereas using individual bonds it takes time to build a full portfolio. All of the issues that would be required to attain the desired characteristics of a portfolio might not all be available at the same time, or costs to purchase the bonds may be prohibitive to be done all at once.
Income can be more quickly reinvested when using funds, whereas proceeds from individual holdings likely need to accumulate as cash until it is sufficient for a round lot purchase or the desired bond becomes available. Bond funds then avoid the issue of being un-invested and likely earning a lower return. Typically, income is held in cash or money market funds under a separately managed account, which would lower the bond portfolio’s performance. This is especially applicable in the mortgage backed securities market as payments, and the breakdown between interest and principal within the payments, is constantly fluctuating based on interest rates. A bond fund can better handle the fluctuations by reinvesting the proceeds in new securities that have different coupon rates.
A bond fund can also maintain its characteristics better than a portfolio of individual bonds. Whereas the separately managed accounts may have to wait to purchase a particular bond for the portfolio to maintain its characteristics when a bond matures, maturing bonds represent a much smaller portion of a bond fund and therefore their characteristics are not as affected. This is important because the duration of a separately managed portfolio may fluctuate more than the desired target and the result could hurt the portfolio’s performance.
Bond funds have higher liquidity than investing in individual bonds. If a partial liquidation is needed a portion of shares in a bond fund can be sold, however selling one bond alters the characteristics of the portfolio in a separate account. Otherwise small portions of each bond type will need to be sold, which would not be possible. Also, some bonds are less liquid than others thus one might be precluded from selling or forced to take a deep discount.
It is often stated that the benefit of owning an individual bond is that regardless of if the security’s value rises or falls you will receive your principal back at the maturity of the issue. With a bond fund you do not have that same guarantee as there is no ending date to the fund. However, this is a simplistic view. Holding a bond to maturity does not provide added value to selling a bond that is currently below its par value as, excluding transactions costs, one can buy a newly issued bond with a similar maturity that will have a higher coupon rate. While the bond value will appreciate one forgoes the higher coupon payments that would be gained by selling the existing bond. If a bond is above the principal balance there won’t be a real economic gain because you will be reinvesting in a bond that has a lower coupon. In addition, if one is holding a bond to maturity and they are simply reinvesting those proceeds, and not using the principal to fund a cash flow, then there are no benefits to holding a bond to maturity.
Bond funds are also superior when one considers costs. Funds typically have lower management costs as the costs for the fund’s legal, administrative, management, etc. needs can be spread across a greater asset base than with a separately managed account with individual bonds. With higher expenses it is more likely to underperform an index. Funds, due to their size, can also command better bid-ask spreads than a separately managed account with smaller bond portfolios, however when separate account managers are large institutions they can command similar spreads.
The benefits to owning individual bonds are derived from increased control and known payments. One can make security specific ownership decisions and will be able to match future liabilities with specific bonds that have the same maturity and face value when owning an individual bond portfolio.
The value at any point in time is uncertain with a bond fund where it is a known quantity with individual bonds. Therefore, one can purchase a bond that exactly matches a future liability so that when the security matures the funds will match the liability. This asset-liability matching does not take into consideration inflation however. Matching longer term liabilities therefore is a harder exercise and can result in the liability being over or underfunded. The strategy works better for known liabilities and for shorter time frames.
Separately managed accounts also enable the investor to hold highly customized portfolios like targeting a specific credit quality and/or characteristics. Bond funds are typically more diverse amongst their sector, but if an investor has a specific liability to hedge against, a more customized portfolio may be necessary.
With a bond mutual fund you won’t know exactly what income you will be receiving over the course of the year whereas with holding a portfolio of bonds you will know the specific coupon payments and the timing of each. One can then be better able to plan ahead for the year with a known income stream.
There are many benefits to holding bond funds over individual bonds. Bond funds provide greater, more easily achieved diversification, better liquidity, income can be more quickly reinvested, the characteristics of a fund are more easily maintained, and they are more cost effective. While there are some more customized situations where owning a portfolio of individual bonds may be preferable, in the vast majority of cases we recommend deriving a portfolios fixed income allocation from bond funds.