Need Bonds? Here Is What to Weigh Next

Need bonds? Then, like equity investors, you face a choice: Should you use individual bonds or bond funds (including ETFs)? Too often, it seems investors automatically resort to the former, presuming individual bonds are superior to bond funds because you can hold them to maturity and get your original investment back.^[i]But in reality, bonds and bond funds each have pros-and cons-to consider. Applying the fallacious principle that individual bonds are better in all situations can expose your principal to more risk than you may appreciate.

Understanding how individual bonds and bond funds trade is helpful when deciding which option is best for your situation. Individual bonds trade "over the counter" (OTC), either through a dealer network where buyers and sellers trade through electronic trading systems or (get this!) by telephone. Dealers make markets in bonds, quoting prices at which they would like to buy and sell. Because they are decentralized-unlike stock exchanges-dealer networks are less efficient. For example, various dealers could quote different prices for the same bond. There are an overwhelming number of bonds on the market. While many publicly traded companies have one or two types of stock (common or preferred; perhaps voting and non-voting), a single company typically has many different bonds.

Each new issue is unique from the same company's previously issued bonds. Take Exxon for example-currently there are 19 different Exxon bonds available.^[ii]Though they are all Exxon bonds, different covenants (terms in the agreements), maturities, call options and other factors can make analysis daunting. Conversely, bond funds-especially ETFs-are easier to trade. Many target specific factors you can use to build your fixed income exposure according to the general criteria you want.

Individual bonds are usually quoted based on the last trade. Because there are so many more bonds available, many have limited trading volume and therefore limited liquidity. It isn't unusual for issues to go days or even weeks without trading. Whether the price you get in a quote or see on your brokerage statement is even accurate may be in question. Conversely, funds price either intraday (ETFs) or daily (mutual funds), giving you a better idea of portfolio value.

To us, this issue-liquidity (of any investment)-is crucial. It boosts transparency and positions you best for the unknown. After all, if you need to sell individual bonds in a pinch, you lose the supposed benefits of holding to maturity and potentially realize those losses you thought holding forever insulated you from. If your positions have limited liquidity, you might have to sell at a steep discount or wait longer than you'd like.

Now, for investors working with sufficient capital to get broadly diversified in individual bonds, that is less of a concern. If you or your financial professional don't like pricing on one bond presently, maybe you sell another that's more favorable. But too often, we see investors who are far from sufficiently diversified using individual bonds. This is partly because bonds usually trade in larger blocks. Par value is commonly $1,000, so it is pretty easy for an individual position to become a large portion of your assets. Hence, we often see investors with 10%, 15% or more in a given individual bond issue. Their entire fixed income allocation wrapped up in a couple of positions! That's a lot of risk to take! What's more, to achieve proper diversification within fixed income, investors must consider bond type, maturity, credit quality, issuer, sector, options, liquidity and other factors. It can be done-and done very effectively. But it can be much harder than using funds.

With the rise of ETFs, one real benefit is that you can target each of these factors very narrowly. Since the fund has pre-stated ownership criteria, its managers help monitor according to those criteria. A fund targeting investment-grade corporates maturing in 7 to 10 years, for example, will manage underlying holdings to keep the fund's overall average maturity in that range. That can help you in managing for the level of interest rate risk you need. Similarly, you can target varying issuer credit quality, default risk, yield and issuer type. As such, funds help facilitate diversification-and active management for expected market conditions-within fixed income. It likely requires more time and attention to build and manage the same sort of diversified portfolio when using individual bonds.

Now, the flipside of this is funds will carry fees for these benefits. This is why we specifically mention ETFs, as they are targeted and cheap. You can cost-effectively blend multiple ETFs in a variety of ways to generate the type of broad fixed income exposure you want. (This is not passive management, by the way). Pooling investments in funds or ETFs will have some tax drawbacks to be aware of, like the fact funds pass through capital gains to you. So, you must weigh funds' efficiency against the benefits we ran through before. And, finally, owning a fund doesn't let you get as specific as you might in individual securities.

So to us, the decision of whether to go with bond funds or individual bonds isn't as automatic as many presume. There is a lot to weigh, and neither option is inherently better in all circumstances.