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Are Bonds Better Than Owning a Bond Fund?
By: Stephen Spencer, CIMA®, Senior Institutional Consultant

Some investors believe that owning individual bonds, either through a laddered bond portfolio or separately managed account (SMA), will lead to better investment results when compared to owning a bond mutual fund. This may be fueled more recently by fears of rising interest rates coupled with the belief that directly owning bonds removes some component of interest rate risk and conversely, pooling your dollars with other investors in a bond mutual fund inherently leads to subpar performance. These perceptions are not entirely accurate and the advantages and disadvantages of each bond vehicle should be considered more thoroughly. 

Interest rate risk
Owning individual bonds through a laddered portfolio or SMA does not shield an investor from interest rate risk any more than a bond fund. Assuming the underlying bonds have the same duration and therefore subject to the same interest rate risk, the market value is subject to the same volatility associated with interest rate changes whether in a ladder, SMA or fund. The vehicle itself makes little difference as long as the bond fund isn’t a forced seller due to fund outflows from other investors, which proper liquidity analysis should identify prior to investment.

Diversification
Bond funds often hold 700 to more than 1,000 individual bond securities diversified by sector, issuer, industry and maturity - many more than an individual investor might theoretically hold. SMAs typically hold fewer securities, anywhere from 50-200, depending on the account size. Smaller individual position sizes are less liquid and more costly to trade, particularly corporate bonds and mortgages, so smaller SMAs will generally hold fewer individual positions to dampen some of the liquidity/cost headwinds. While SMAs can be managed with $3 million or less in assets, many bond investment managers require $10-$20 million or even far larger for appropriate diversification. A bond ladder often holds far fewer securities than a fund or SMA and is far less diversified for that reason.

Investment management and trading costs
Institutional share classes of core fixed income bond funds generally have expense ratios between 0.30% to 0.45% but SMAs generally have expenses of 0.35% or less depending on the size of the account. As assets increase, overall expense ratios for SMAs typically decline as fee breakpoints are achieved.

Investors may overlook transaction costs as a meaningful component of bond portfolios. Trading costs are not always explicitly known or easily identifiable by investors but the account’s net returns will undoubtedly reflect the impact of those costs. Individual securities are subject to a bid/ask spread for execution. The spread represents the difference in the price at which the dealer is willing to buy a bond (“bid”) and the price at which the dealer is willing to sell the same bond (“ask”). The spread between the bid (lower) and ask (higher) varies based on liquidity of the security, bond sector and trade size. Smaller-sized trades often have much higher spread cost than larger-sized trades, meaning that large mutual funds usually trade at much lower spread cost than smaller-sized trades from a separately managed account or individual bond ladder. Spreads tend to be largest in non-U.S. Treasury sectors but scale can be an advantage in Treasury bond transactions as well.
Exhibit 1
Bond Ladders
We generally do not recommend bond ladder strategies for institutional portfolios. Ladders typically lack sufficient diversification among sectors and issuers and transaction costs will be higher than a fund or SMA. Bond ladders are also likely to suffer from a cash drag. For example, the coupon interest may be too small to be reinvested at similar rates as the rest of the ladder and therefore earns lower money market returns instead of being reinvested at higher yields. Consequently, a ladder would be expected to generate lower returns than a comparable bond fund or SMA. If shorter duration is desired, a short-term bond fund or SMA might be able to accomplish that goal more efficiently than the ladder.  

Bond ladders are sometimes perceived as simple, do-it-yourself strategies. However, finding the right bonds to purchase can be difficult given the complexity of fixed income markets. An understanding of the market and associated risks are required along with the tools to regularly monitor changing conditions. Bankruptcies, defaults and fluctuating interest rates are just some of the complexities that may challenge bond investors and the risks are only amplified with fewer individual positions. Even with comprehensive, up front analysis, an investor may not have the time or expertise to maintain constant monitoring of the portfolio, which is required to manage risks properly.    
 
Separately Managed Accounts
A separately managed bond account can be a very good fit for larger asset balances, particularly where there are unique constraints and a need for customization. An organization that adheres to specific Environmental, Social and Governance (ESG) investing criteria and wishes to avoid certain issuers based on their ESG requirements may prefer separately managed accounts. Another example is a defined benefit pension plan that elects to customize the fixed income portfolio to match the liability characteristics of their plan to reduce funded status volatility.  

Other benefits of bond SMAs include professional investment management, broad diversification of holdings (especially with larger SMAs) and generally lower investment expenses than a comparable bond fund. An investor that expects regular cash flows in or out of the SMA should consider the additional transaction costs associated with that trading activity (bid/ask spread). Frequent trading to either raise cash or invest cash contributions can add cost and therefore nullify the investment expense savings advantage that SMAs might offer relative to bond funds. Lastly, custody costs of a bond SMA present another consideration, as transaction-based custody fees may add to the total cost of the SMA as well.        

Bond Funds     
Bond funds are a good fit for most investors. They offer superior diversification for even very small balances. Funds are professionally managed and institutional share classes frequently carry competitive investment expenses. They also provide daily liquidity and often aggregate trading activity into larger trades that reduce transaction costs and the potential drag on fund returns.  Bond funds do have to manage daily investor cash flows, but skilled fund managers monitor those trends closely. Most large bond funds maintain sufficient cash cushions to meet redemption requests without materially impacting the broader portfolio. 
Exhibit 2
Professional management of bond portfolios is critical in this constantly changing investment environment. Bond investors need to thoroughly consider their goals and unique circumstances to determine the best vehicle for their portfolio.
For assistance with evaluating investment vehicles or other fixed income considerations, please contact any of the professionals at DiMeo Schneider & Associates, L.L.C.
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