“It’s hard to see why a bond fund is any riskier than a portfolio of individual bonds when they’re both holding the same securities. “

By Frank Censullo on April 4, 2023

Of all the investing pearls of wisdom, perhaps none is as widely held as the idea that if you hold your bonds to maturity, you get your money back, and it is for this reason that individual bonds are often deemed less risky than comparable bond mutual funds or exchange-traded funds (ETFs).  Many investors, therefore, question the wisdom of including bond funds in their portfolios.

It’s true that if you hold an individual bond to maturity, you’ll get your principal back (assuming no default by the issuer), while bond funds have no terminus.  For many investors and television talking heads, that’s the end of the story.  At Lexington Wealth Management, we don’t argue bond funds are better.  If a client has the significant resources needed to build out a diversified portfolio of individual bonds, we’ll help them do it.

We just don’t believe the risks of bond funds are any greater.  Bond funds are simply diversified portfolios of individual bonds, and both are similarly impacted by rising interest rates, credit downgrades, issuer defaults, etc.  Bond funds have no maturity date, but each individual bond within a fund does.  For us, it’s hard to see why a fund is any riskier than a portfolio of individual bonds when they’re both holding the same securities.

Ups & Downs

In an effort to combat inflation, the Federal Reserve increased the Fed funds rate – the interest rate banks charge each other for overnight loans – seven times last year, and twice more so far in 2023, by a combined 4.75%.  Generally speaking, when rates rise, existing bonds lose value because new bonds – issued at the prevailing higher rates – are more attractive to investors.  A bond’s yield is stated as a percentage of that bond’s price, so when the price falls, the yield rises, making it more comparable to newer issues.

If an investor withdraws assets from his or her portfolio after bond prices have fallen, it’s not going to matter whether he or she owns individual bonds or bonds funds – both will have lost money.  An individual bondholder might argue he or she can simply hold onto those bonds that have temporarily declined in value, wait for them to mature, and thereby avoid suffering any losses.  Real life, however, often intervenes.  Tuition bills need to be paid, homes get purchased or renovated, and other investment opportunities present themselves.  An investor cannot always “wait it out” and avoid market risk.

The recently well-publicized struggles of Silicon Valley Bank (SVB) are a case-in-point.  The bank invested its excess deposits in bonds with longer-dated maturities at historically low yields.  When the Fed began rapidly hiking rates last year, the value of SVB’s bonds declined precipitously.  As their customers began withdrawing their deposits, the bank was forced to sell securities at a loss to generate liquidity.  Owning individual bonds, therefore, did nothing to protect SVB, because they were unable to hold them to maturity.

Likewise, if one is not making withdrawals but is keeping one’s money working, as with a bond ladder (a portfolio of bonds that mature at regular intervals), then as individual bonds mature, the proceeds will need to be reinvested.  In that case, the individual bond purchaser is subject to the same risk as the bond fund buyer – that prevailing rates are now higher and purchasing power has been diminished.

The fact that a bond can be held to maturity does not result in an economic benefit to the investor.  While any unrealized loss will gradually be overcome as the bond approaches its maturity date, its lower coupon generates less income relative to new issues.  Think about it: if holding bonds to maturity in a rising rate environment was somehow a winning strategy, then why wouldn’t investors sell their bonds at a profit when rates are falling?  The reason is because they would then be forced to buy new bonds that are yielding less.

Spreading it Around

Proponents of owning individual bonds also make the case that investors in bond funds are subject to the whims of their fellow investors who, in times of market turmoil, might engage in panic selling.  This, they argue, could force the fund manager to sell bonds to meet redemption requests and, thereby, generate capital gains or losses.

A bond fund must distribute its capital gains to investors and will typically do so at or close to year-end.  A fund cannot distribute its capital losses but can use them to offset current or future gains.  The same is true for stock funds, yet seldom is it argued this renders them riskier than a portfolio of individual stocks.  Most investors recognize the benefits of stock funds, and bond funds share similar advantages.

Bond funds offer broad diversification and professional management, and they typically have steady inflows of cash that can be put to work strategically to take advantage of higher-yielding opportunities.  They also enable investors to include many different types of bonds – U.S. government, corporate, municipal, high yield, foreign, etc. – in their portfolios.  Even if a client has individual bonds as the core of his or her fixed-income portfolio, we here at Lexington Wealth Management are likely to recommend funds as well in order to capture the risk/return characteristics of other types of bonds.  High-yield (“junk”) bonds, in particular, are well-suited for the fund structure, as it’s important to hold a great many bonds in order to achieve adequate diversification.

Funds and ETFs come at a cost, to be sure, but we look to utilize low-cost options, and buying individual bonds can come at a cost, too, in the form of dealer spreads (unless you buy bonds directly from an issuer like the US Treasury).  The spread is the profit a dealer builds into the price of a bond when he or she sells it to you.  Brokers at the big investment firms are notorious for telling their customers they will manage their bond portfolios “for free,” meaning they won’t charge an ongoing fee for assets under management (AUM).  What they don’t often disclose is that the bonds they purchase for a customer’s portfolio are from the firm’s own inventory, and these firms profit mightily by jacking up the prices.  It’s not easy for an individual investor to determine what a fair price is for a given bond.

At Lexington Wealth Management, we don’t select individual bonds for clients’ portfolios.  If a client wants to own individual bonds, we’ll hire a manager (at a cost comparable to an ETF) to shop the marketplace, select bonds for the portfolio, and negotiate prices.  Fund managers do the same for their investors.  These managers have far greater clout than individual investors and can get the best pricing for their clients.  They also provide ongoing oversight of the bonds.  As a client of ours, whether you invest in individual bonds or bond funds, you’ll never have to worry about unfair pricing.

An “Anchor to Windward”

Owning individual bonds – as through a customized separately managed account – will enable an investor to tailor a portfolio to his or her particular needs and allows for a measure of control over security-specific decisions.  Fund ownership, meanwhile, offers significant diversification and provides a convenient way to put new cash to work – or access it – quickly.  There are funds to capture virtually any segment of the bond universe, income is generally paid monthly, and it can be automatically reinvested.  Both ownership structures have their advantages and disadvantages.  What’s most important is to capture the asset class as cost-effectively as possible.

If, over time, rising stock prices are the wind in your portfolio’s sails, it’s the bonds, which are far less volatile and provide a steady stream of income, that keep the ship from running aground.  At Lexington Wealth Management, we believe bonds – whether purchased individually or through a fund – are an essential component of a well-diversified portfolio.

Disclosure
Lexington Wealth Management is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC. This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be proLitable. Past performance is neither indicative nor a guarantee of future results. The investment opportunities referenced herein may not be suitable for all investors. All data or other information referenced herein is from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other data or information contained in this presentation is provided as general market commentary and does not constitute investment advice. Lexington Wealth Management and Hightower Advisors, LLC or any of its affiliates make no representations or warranties express or implied as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. Lexington Wealth Management and Hightower Advisors, LLC assume no liability for any action made or taken in reliance on or relating in any way to this information. The information is provided as of the date referenced in the document. Such data and other information are subject to change without notice. This document was created for informational purposes only; the opinions expressed herein are solely those of the author(s) and do not represent those of Hightower Advisors, LLC, or any of its affiliates.