Individual Bonds Versus Mutual Funds

Potential clients I meet with sometimes have a portfolio of individual municipal bonds that they have purchased through a stockbroker. In far too many cases, the investors don’t really understand exactly what is in their investment portfolio.  They believe that because they have more than a dozen different bonds that they have essentially diversified their risk.  Generally, this is not the case. Moreover, these investors have no idea how much it really cost them (in the way of commissions or mark-ups) to purchase their bonds.

Whether or not you have a portfolio of individual bonds, you may still benefit from reading this because, the fact remains, what you don’t know about investing can hurt you financially.

As discussed in a previous post, many bond investors inadvertently take on excess risk by buying high yielding (generally synonymous with low quality) bonds.  This post discusses the trade-offs between buying individual bonds and owning a bond mutual fund.

Municipal Bond Funds and Individual Bonds, a report prepared by the Vanguard Group, discusses the pros and cons of buying individual bonds or mutual funds.  As you may know, the Vanguard Group is in the mutual funds business, so you might be suspicious of its conclusions.  Although their analysis could be construed as self-serving, I am, nonetheless, convinced that they are right.  My advice is that you read the entire 11 page report, but if you don’t have the time, here are some relevant excerpts. (Emphasis added.)

Municipal bonds—overview and investment considerations

Municipal bonds are initially issued in the primary market, where pricing is based on market conditions and demand.  It is generally more cost-effective to buy these bonds in the primary market, but institutional (mutual funds, pension funds) buyers dominate that market, and historically, it has been difficult for individual investors to compete with them for the limited bond supply.  As a result, most non-institutional trading is relegated to the secondary market, in which existing bonds are resold.

Drawbacks of trading municipal securities in the secondary market

Trading in the secondary market for municipal securities can be very problematic and expensive.  Unlike most other financial markets, in which price and execution are transparent to the investor via real-time bid–ask quotes, the secondary municipal market provides very limited real-time pricing and execution.

As a result, to be successful in this market requires deep knowledge, understanding, and experience in how it operates.  Compounding the problem is that, in the secondary market, purchases or sales in less than “round lot” quantities are marked up or down to reflect the unattractiveness of these sizes for bond dealers.  In addition, municipal bonds are not as actively traded as taxable bonds, such as U.S. Treasury or corporate issues.  As a result, municipal bonds are less liquid than taxable bonds and have higher transaction costs.

Comparison of municipal bond funds and individual bond portfolios

Several factors should be considered when evaluating the suitability of municipal bond funds versus individual bonds for a portfolio.  These factors include diversification, cash-flow treatment and portfolio characteristics, costs, and direct control of the portfolio.

Diversification

a.  A bond fund provides broader diversification than a portfolio of individual bonds.  Bond funds typically provide substantially more diversification among issuers, credit qualities, and maturities, as well as in the range of individual bond characteristics (for example, callable, noncallable, prerefunded, discount, and premium).

Much of this is possible because a bond fund has a larger pool of investable assets, along with the professional staff needed to conduct credit analysis.

For a self-directed individual, creating a well diversified bond portfolio typically requires a significant capital investment to obtain exposure across issuers, credit qualities, maturities, and so on.

Cash-flow treatment and portfolio characteristics

a.  Bond funds provide more timely investments of initial principal and periodic income cash flow.

b.  Bond funds provide more consistent risk characteristics (the most important of which is duration).  Because of their more regular, ongoing cash flows, mutual funds are better able than alternative vehicles to maintain more stable portfolio risk characteristics over time.

c.  Bond funds make liquidations, especially partial liquidations, notably easier.  Liquidating bond-fund shares does not change the characteristics of the fund’s bond exposure.

Costs

Our review of costs included bid–ask spreads, management fees, and sales charges or commission costs (collectively, “transaction costs”).  Costs are important because they directly reduce a portfolio’s total return.  For fixed income investments, as opposed to equity investments, costs tend to be a more significant drag on performance, and therefore exert one of the greatest influences on returns.

a.  Bond funds typically pay significantly lower bid–ask spreads than individual investors.  Retail trades of less than $100,000 per bond cost between 100 and 200 basis points morer than that for an institutional trade.

b.  Bond funds charge an ongoing management fee (expense ratio) for expenses related to the operation of the fund.

While the annual expense ratio is frequently cited as a drawback for funds, in reality it is generally more cost-effective to pay the expense ratio for years, rather than to risk paying a large spread when buying a bond.

Control of the portfolio

One advantage of self-directed individual bond portfolios … over mutual funds is the owner’s ability to influence portfolio decisions.

a.  Bond mutual funds don’t offer investors the ability to influence the selection of the bonds.

b.  Bond mutual funds cannot pass realized losses through to individuals.

c.  Bond mutual funds do not have a maturity date.  Therefore, the value of the fund at any point in the future is uncertain.

Conclusion

Vanguard believes that the vast majority of municipal bond investors are better served using mutual funds.  Only investors with resources comparable to those of a mutual fund can afford to put the control benefits of owning an individual bond portfolio ahead of the benefits of investing in a mutual fund.  The advantages of mutual funds over individual bond portfolios include better diversification, generally lower costs, typically higher after-tax returns, and more efficient management of cash flows and portfolio characteristics.  The advantages of individual bonds over bond mutual funds revolve primarily around control issues that result from direct ownership.  An investor must assign a very high value to those control aspects to justify the higher cost and additional risk involved in owning individual securities.

Note

The analysis focused on municipal bonds, but similar considerations apply to corporate bonds. Also, the Vanguard Group has very low cost mutual funds, so the trade-off is pretty clear between individual bonds and their mutual funds. Other companies, such as Fidelity or T. Rowe Price, also have low cost mutual funds, provided that you purchase them directly or through a fee-only financial advisor. If you purchase mutual funds through a stockbroker, you may end up paying very high fees, effectively negating the low-cost aspect of mutual funds. As always: Buyer beware.