Investing in Individual Fixed Income Versus Using Bond Funds
Funds have to sell bonds when other fund holders sell their positions which may create a taxable event for which you may be accountable. Example: You may buy shares of a bond fund that own bonds that could have been bought years ago and now trade at significant premiums. When bond funds sell out of bond positions, either for redemption purposes or to protect against volatility, you may have a capital gain in the bond that you may not participated in, yet you still have to pay taxes (capital gain) as an investor.
Liquidity Crunch Caused By Out-Sized Bond Positions
Bonds are very different from stocks in that a company will typically only have one class of stock shares but may have many different bond issues. That means that while the stock only has one market where all the trading is done, the bond side has many different smaller markets for buying and selling. Banks in particular can have dozens of bond issues. This lowers the liquidity for buying and selling each bond issue making trading much more complicated. A buy of 100,000 shares of stock may move the stock price 1% but a 100,000 bond order can move a bond price 5% or more depending on what market you’re trading through and how many other buyers and sellers are active.
A $500 million stock position may account for 1% of the shares available while a $500 million bond position could be as much as 30% of the issued bonds. Buying and selling that bond position can move prices significantly in either direction. If there is a negative event (i.e. bankruptcy, federal investigation, etc.), the manager may not be able to sell more than a handful of bonds making big funds less nimble when it matters the most.
Mass Redemption Negative Effects
All mutual funds at some point fall out of favor and cause investors to flood the fund with requests for redemptions. The fund then may be forced to sell positions they don’t want to because they need to raise cash as fast as possible. This can create even more of a challenge when trying to determine if a fund can meet your long-term income need because what they own today may be significantly different if markets change and redemptions pick up.
Unpredictable Revenue Stream
Many investors, particularly those in retirement, buy bonds to provide the income they need to pay the bills. Many of the largest/most-popular funds have a total return mandate which means they are trying to beat the market over both the short term and long term. If the manager of one of these funds believes interest rates will rise, then the portfolio will be re-balanced towards lower yielding bonds. A portfolio yielding 5% can change to a 1% yield very quickly. If the manager is wrong, your annual income may not only be less but each year of lost income that passes will need to be made up. Typically, with individual bonds, you know what your income will be and when you will receive it. Buying bonds with a lower yield to maturity means the manager is accepting the fact that they will receive less income and have less upside potential for a given time period.
Interest Rate Risk Is Much Higher
Interest rate risk is the risk that interest rates will rise and bond prices will fall. If you hold a bond until maturity, the money you will receive is fixed to the principal amount and you therefore have no interest rate risk if held. The risk comes in when you sell a bond prior to maturity. Bond managers rarely hold intermediate- or long-term bonds until maturity and are subject to greater risk that rates will rise. This may increase overall risk and the bond fund therefore may not be helping manage the risk of the overall portfolio as well as expected.
Bond Index Funds Create Inefficiencies
Most bond indices are made up of the largest bond issues much the same as most stock indices are heavily weighted towards the largest companies. Because bonds are less liquid, being added to an index can push prices higher and yields lower when funds linked to the index have to buy. The opposite happens when those funds are forced to sell. Bonds in an index may offer lower yields and less value than bonds outside of the index. This creates a real opportunity for more agile investors to build portfolios with better yield and risk advantages.
Some bond indices change components often, particularly if an index targets a certain time frame like intermediate, long term, 5-7 year, 10 year, etc. As a bond issue gets closer to maturity, it will fall out of these types of indices and could cause an index fund to sell regardless of the current price. As multiple index funds sell positions, this creates more downside pricing risk.
Another issue with indexed bond funds is the difficulty in recreating the index. We have covered the fact that bond markets are less efficient than equity markets. When a manager goes to recreate the index, they may not be able to buy all of the components in the index if none are available for sale. The resulting portfolio may be vastly different from the index it is supposed to track. Some managers make use of “corporate substitution” in their bond index funds allowing for up to 15% of the portfolio to consist of bonds that aren’t even part of the index. Also, managers may use derivatives in the portfolio which may not be appropriate for every investor. You can see why a higher percentage of bond funds compared to equity funds under-perform their index. In addition, index funds are not normally managed for tax efficiency.
Consider All The Costs That Affect Yield
Considering many bond funds currently have low yields, even a small management fee can significantly reduce the income provided. If the fund is currently yielding 2.0% and has a 0.65% management fee, a third of the income from the fund is going directly to the manager. When you consider that the fund fee may include things like marketing costs on top of management and trading fees, the cost may not be worth the benefit you receive. If your advisor is charging a fee on top of the management fee, the net yield from fixed income could possibly even be negative meaning you are paying to own the bond portfolio instead of it paying you.
If a bond fund’s expense ratio is .50% and the advisor fee is 1.00% and the fund has a yield of 2.5% your cost is 60 percent of the total return of the net return─a hefty price to pay for such a low rate of return.
Also, bond funds, whether active or passive, may trade more than is beneficial or desirable for individual investors. Bond markets are less efficient when it comes to buying and selling. That means the more trading a fund does, the more the fund may be losing to trading slippage. For example, if you lose 0.1% of a bond yield to trading cost each time you buy, you won’t be losing much buying a bond that you plan to hold until maturity. If you lose that 0.1% across the whole portfolio five times in a year and five times each year after that, you may be paying more than you realize.
Market Timing Is A Losing Proposition
Active bond funds attempt to time the market by moving in and out of different kinds of bonds and moving up and down the maturity ladder. For example, entering 2014, most fund managers and pundits alike believed rising interest rates to be a foregone conclusion but it just hasn’t materialized. Rates have moved lower and longer-term bonds have provided much better returns. This can create a long lasting negative drag to investors that require a certain yield to meet their goals.
Where do bond funds fit in? We believe there are three reasons investors/advisors are not be able to take full advantage of investing in individual fixed income securities. First-small investors don’t always have the skill set or the resources and technology to construct a bond portfolio. Second- large investors that don’t have time or their advisors with proper technology to build a fixed income portfolio (usually you need a team and technology to help). Third- the lack of a dedicated fixed income trader.
Large bond funds may be most appropriate for institutional investors that use bond funds to trade in and out and are less worried about yield. Why have you not heard more about this? We believe that few investors really understand the yield shortfalls of bond funds because they either aren’t retired or their equity holdings have made such progress over the last several years that the shortfall in bond fund yields is not as apparent. However if yields stay low and equity returns slow as more of the work force retires, this could be a problem!
Finally, we at Linden Thomas are not against bond fund investing. We do offer this to our clients. We have found, however, that if a client has a long term goal for both yield and growth, the shortfall in bond fund yields often means that the equities in an individual’s portfolio must make up for the weakness in bond fund results. This ultimately means a greater exposure to equities has to take place or greater returns must be sought through more aggressive funds.
Contact our office for a no-cost, no-obligation, comprehensive evaluation of your current financial portfolio. 704-554-8150 or 877-554-8150.
Mutual Funds investing involves risk. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost.
Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity. Yields and market value will fluctuate so that your investment, if sold prior to maturity, may be worth more or less than its original cost. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the value of your investment.
Linden Thomas And Company is not a legal or tax advisor.