Bond Basics Part II: DIY or bond funds?

BY Chamath De Silva | 26 September 2017
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Should you hold individual bonds and “do it yourself” or a diversified bond fund/ETF? One commonly held belief in investing is that holding individual bonds entails less risk than bond funds, due to the return of principal at maturity. Is this correct? If so, does it matter? Ultimately, it depends on the role bonds play in your portfolio, but I would argue that for the majority of investors, bond funds are likely the superior option.

Before I explain the numerous advantages bond funds have over individual bonds, let’s first start off with situations where investing in the latter may be preferable. If there is a need to match known future liabilities (i.e. rather than using bonds as a portfolio allocation), then buying individual bonds may be the less risky option. In addition, if you have undertaken extensive credit analysis and have a very strong view on a particular bond or issuer, then trading individual bonds may also make sense. However, if bonds are simply used as part of a diversified asset allocation strategy, and the principal will simply be reinvested, bond funds and bond ETFs provide significant benefits for most investors. Here’s why:

Access and diversification

Unlike the equity market, the bond market is primarily traded over-the-counter (OTC) and is not particularly accessible to retail investors. Minimum parcel sizes of up to $500,000 combined with different clearing arrangements (A$ bonds settle through Austraclear, Euroclear or Clearstream rather than CHESS) make it difficult for most investors outside the high net-worth segment to access fixed income securities at fair prices. Given the barriers to even buying a single bond, investing in a portfolio of bonds or building a bond ladder for diversification, it is just not feasible for the typical retail investor or smaller institution. And even if you are able to invest in single bonds via other means, an investor will still need to put together a portfolio of bonds that makes sense, requiring significant research and credit analysis if it is to be done properly.

Costs

The OTC bond market is an anachronism in today’s high tech world. Although exchanges and electronic trading have been a part of equities and futures trading for some time now, bond markets have largely been resistant to such changes. A 2016 BIS report on electronic trading found that globally, only around 40 per cent of investment grade bonds were traded electronically (for sub-investment grade, this share is even lower at 25 per cent), compared with 75 per cent for equities and 90 per cent for futures. In practice, most bond trading is conducted one-on-one with a dealer (still often over the phone!), with the main transaction cost being a bid-offer spread rather than brokerage. As a result, the market is highly opaque, with large disparities in pricing for any particular bond across dealers and trade sizes – retail sized trades typically incur much higher transaction costs (in terms of prices paid or received) compared to institutional trades. The lack of transparency also makes it difficult for retail investors (or anyone without a Bloomberg terminal or dedicated data subscription) to observe true market prices or to calculate the spreads above fair values they pay.

Liquidity

Another important consideration is liquidity: how easily we can convert our bond holdings to cash at fair prices. Outside government securities, liquidity in the OTC bond market is highly variable, with many bonds thinly traded or “locked up” completely. In addition, a dealer’s willingness to even buy a particular bond often depend on their own balance sheet considerations and inventory levels. Conversely, bond ETFs typically have consistent liquidity due to the presence of dedicated market makers and being traded on a centralised exchange. In fact, the simple act of moving a portfolio of OTC bonds onto the exchange via an ETF often entails a liquidity transformation, with many bond ETFs enjoying significantly tighter bid-offer spreads than their underlying constituents face in the OTC market.

Constant risk profile

More applicable to fixed than floating rate bonds, the main risk faced by holding investment grade bonds is duration, or the sensitivity to interest rate movements, which is closely related to the maturity (see Bond Basics Part I for more on this). As a bond approaches maturity, its duration falls and so does its interest rate risk, eventually reaching a zero. If reinvested in a new bond, the duration, and hence interest rate risk, will increase again to reflect the new bond’s maturity, creating a very lumpy risk profile over the investment horizon. A bond fund, in contrast, will maintain a much smoother duration and a much more consistent risk profile, which helps significantly in portfolio construction and asset allocation. Furthermore, corporate bond funds will hold bonds from a number of different issuers, reducing both bond and issuer-specific risks.

Rebalancing

As bonds pay coupons and principal payments, the investor must decide what to do with those cash flows. Assuming, they are reinvested (as opposed to consumed), the investor has a choice of reinvesting back into bonds to maintain the overall fixed income allocation. Bond funds do this as a matter of course, and typically incur significantly lower transaction and trading costs than what an individual investor would face.

In addition, bond funds (such as QPON), are able to exploit the yield or credit curves seeking to generate additional returns when rebalancing into newly issued and cheaper securities (and selling older securities that become more expensive). In contrast, holding bonds to maturity will see any temporary capital gains lost as bond prices are pulled towards their face values.

Conclusion

When deciding to add fixed income exposure to your portfolio, it is important to have a clear sense of the role they will play and be aware of the transaction costs you will incur trading them (which can be significant for smaller investors). If bonds are simply used as a part of a broader asset allocation or to diversify equity risk, then bond funds may be a superior option to purchasing individual bonds – not only on the basis of access and diversification, but also due to favourable costs from tapping wholesale liquidity and additional returns from rebalancing. In addition, although recent developments have allowed investors to more easily get exposure to individual bonds on the exchange, they still require investors to have the ability to be able to determine which bonds to purchase and to select an appropriate basket of bonds for  diversification purposes, which may well be an onerous task for most.

 

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