|
Bond investments can be made two ways: buy shares in bond funds or buy individual bonds.
Both methods provide the investor with steady income. Both of their market prices move in the opposite direction of interest rates. Both give shelter from stock market volatility.
Which is better? For most investors, we believe bond funds offer significant advantages that make them the superior investment while individual bonds possess at least two advantages. First, there’s no management fee; though there is a bid/ask spread and commission when you buy and sell the bond. On small orders (block size less than $100,000), bid/ask spreads are often sizable. For the municipal bond market, an entire web site, www.municipalbonds.com, exists solely to document instances in which brokers take abnormally large mark-ups on odd-lot bond trades. This indicates that it is not uncommon for retail investors to sell their bonds at low prices and buy bonds at high prices.
Second, each individual bond provides certain return of principal on the maturity date so long as it does not get called early and does not default. A bond fund has no fixed maturity date, so it cannot guaranty return of principal upon maturity. This advantage is for a single bond only. If you own a set of bonds with various maturities, you have certain return of principal over many years, but not on any given day just as in a bond mutual fund.
What are the advantages of bond funds?
1. Liquidity. It’s easy to cash out of a fund. Shares in a bond fund can be redeemed everyday at net asset value (NAV), in any quantity. In contrast, individual bonds trade in an over-the-counter market with inconsistent liquidity and actually trade more like real estate than like stocks. Once you own a bond, the only way to cash out before maturity is for your broker to solicit bids. The price you receive is whatever the buyer offers, less the broker’s bid/ask spread or commission. As with a bond fund, an investor may lose money when selling an individual bond.
2. Low minimums. Most bond funds have a $5,000 minimum and allow additional share purchases of any amount. Individual bonds are technically $5,000 each, but in reality rarely trade in amounts smaller than $25,000. Any individual bond trade smaller than $1,000,000 is considered an “odd lot,” subject to higher mark-ups.
3. Diversification. Bond funds offer diversification, which helps limit risk. Whether you invest $5,000 or $5,000,000 an investor receives the same diversification in a fund. For an individual investor to build a diversified bond portfolio with no one bond representing more than 5% of the portfolio, the investor would need a minimum of $100,000. In reality, investors would need even more to build a properly diversified portfolio of individual bonds.
4. Professional management. Bond funds offer professional portfolio management. You pay management and operating expenses, and in return a portfolio manager, traders, and credit analysts identify and purchase bonds suitable to the fund’s risk/return strategy. Without a mutual fund, or a separate account, there is no professional management available. The portfolio managers also monitor each of the bonds and the overall portfolio to ensure that it performs as expected.
5. Bid/ask spread. Since millions of different bonds trade in an OTC market, the bid/ask spread is wide. When you buy individual bonds, unless you are an institutional investor, you’re often on the high (ask) side of the spread. But when bonds are purchased in a bond fund, investors benefit from the institutional buying power of the fund most often resulting in lower prices on the buy side and higher prices on the sell side.
6. Funds are simpler. It’s much less work to buy shares in a bond fund, and after you buy it, you can have dividends automatically reinvested. However, building a well-diversified portfolio of quality individual bonds takes considerable time and effort. Once you assemble a portfolio, each bond pays a twice-yearly coupon. Typically those coupons sit in a low-yielding money market fund for long periods since there generally is not enough money to purchase additional bonds.
7. Funds can be purchased in various dollar amounts. Say an investor has $45,500 to invest. Or $232,300. Or $419,650. It would be difficult to find an individual bond in those exact amounts. The investor may search the market for an extended period, settle for whatever becomes available, and leave excess cash uninvested. With a bond fund, the investor can invest any amount instantly.
8. Performance rankings. Bond funds are evaluated for risk and return by independent companies like Morningstar. Investors can use that research to select funds. Performance evaluations are possible because bond fund NAVs are priced daily, giving Morningstar a basis for performance evaluation. Most individual bonds have credit ratings, but no performance rankings.
9. You know your account’s value. Individual bonds are not marked-to-market daily, so you don’t know how much your bond is worth until you ask for one or more current quotes. Bond fund NAVs, on the other hand, are marked-to-market every day the bond market is open. To learn exactly what your shares in a bond fund are worth, simply look at your account statement, check the newspaper, or call the fund’s customer service department.
10. Funds offer flexible investment options. Many fund companies give shareholders a wide berth to maneuver their investments. Many offer one-day redemption for accounts set up for wire transfer (redeem your shares on Monday, you have the cash on Tuesday). Most fund companies offer exchange privileges among their family of funds. Often dividends of one fund can be reinvested into a different fund.
11. Reinvestment of income. Bond funds pay monthly dividends which can be reinvested in the fund at current yields. Bonds pay interest semi-annually, and unless there is enough cash to buy another bond, often times the income payment sits in lower yielding money markets until enough cash is accumulated to buy another bond. In essence, compounding opportunities are greater in bond funds than with individual bonds.
For investors desiring a diversified portfolio of bonds, there are significant advantages of buying an already existing portfolio of bonds within a mutual fund. That is not to say that there is not a place for individual bonds, but the advantages of funds clearly outweigh the advantages of owning individual bonds.
Shares in a mutual fund are not guaranteed or endorsed by any bank, the Federal Deposit Insurance Corp., the Federal Reserve Board or any government agency. Some bonds may be guaranteed by the U.S. government or a municipal government.
Individual bonds and bond funds are subject to income tax on dividends in the year they are received and capital gains tax upon sale of the bond or bond fund, if there is a profit. However, bond funds may be subject to capital gains tax in any year that the fund has a capital gain.
The views expressed by Mr.Ziesenheim reflect his professional opinions and are subject to change.
As with direct bond ownership, Funds that invest in bonds are subject to certain risks including interest-rate risk, credit risk, and inflation risk. The principal value of bond funds will fluctuate relative to changes in interest rates, decreasing when interest rates rise. Unlike bonds, bond funds have ongoing fees and expenses. Shares in the fund are not deposits or obligations of, or guaranteed or endorsed by, any bank, the Federal Deposit Insurance Corporation, the Federal Reserve Board or any government agency.
Individual bonds and bond funds are subject to income tax on dividends in the year they are received and capital gains tax upon sale of the bond or bond fund, if there is a profit. However, bond funds may be subject to capital gains tax in any year that the fund has a capital gain.
Carefully consider the Fund’s investment objectives, risks, sales charges, and expenses; these are found in the prospectus, which is available from your financial advisor or from our download library. Read it carefully before you invest or send money.
