The tradeoffs between bond funds and individual bonds

The tradeoffs between bond funds and individual bonds

The tradeoffs between bond funds and individual bonds

Investors generally have just two options when wading into fixed income for the first time: invest in bond funds or invest in individual funds. While there’s no clearly superior choice, each offers some advantages and disadvantages based on certain considerations.

“In a time of rising interest rates, individual bonds can carry an advantage,” wrote Wall Street Journal contributor Dan Weil. He noted that rising rates depress bond prices, which in turn decrease the value of bond mutual funds and ETFs. Citing figures from Morningstar, he said that US open-end bond mutual funds and ETFs returned just 0.9% on average in 2018.

Individual bonds, particularly high-quality ones, give investors the security of receiving the full par value if they hold to maturity. But in falling-rate environments, when bond fund prices tend to increase, that advantage of individual bond investment evaporates.

Going beyond interest-rate considerations, Weil said individual bonds are more predictable in certain ways. For example, investors will generally know exactly how much interest-rate income they’ll earn from an individual fund, unlike bond funds for which it can vary widely. They also know just how much capital-gains tax they’d have to pay after selling individual bonds, while the figure is impossible to predict for bond funds.

But according to David Carter, chief investment officer at New-York based Lenox Wealth Advisors, mutual funds offer broader diversification, which is “especially important when investing in riskier bonds, such as high-yield or emerging markets.” Individual bond purchases, particularly those in small amounts, can result in high transaction fees; one rule of thumb held by US advisors says that investors must have a minimum of $250,000 in at least 10 bonds for individual-bond investment to make sense.

However on the fund side, fees can also be a problem. Morningstar figures indicate an average annual expense ratio of 0.74% for US open-end bond mutual funds and ETFs. Carter asserted that the trading cost for an individual bond is about the same as one year’s expense fee for a mutual fund with similar bonds; the difference is that the expense ratio on a fund is paid yearly, while trading fees are paid only once if an investor buys a bond and holds it to maturity.

One approach to create diversification with individual bonds is to create a bond ladder, which is designed to lessen interest-rate risk and provide reliable cash flow. But since it requires access to sophisticated advice or the ability to do independent research on individual bonds, a mutual fund or ETF is still a better way to go.

“For investors who decide to invest in a fund, the next question is whether to buy shares in an ETF or a mutual fund,” Weil said. With interest rates still at historic lows, costs are a vital consideration, which means ETFs — with an average annual expense ratio of 0.326% compared to the 0.785% for open-end mutual funds cataloged by Morningstar — are at an advantage.

But according to Michael Sheldon, chief-investment officer at RDM Financial Group, “ETF investors may not get the price they expect when they go to sell a bond ETF,” particularly when market volatility abounds. While ETF prices can change over a trading day, open-end bond mutual funds are priced only once a day at their closing net asset value.

 

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