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Bond Funds Are Way Better Than Bonds Income Strategist | Eric Jacobson

Call Risk Deciding what to do when bonds are called is impor- tant, but judging the value of their call options is critical. When you purchase a callable bond (including mortgage securities, which are much more compli- cated), you are also “selling” an option to the borrower, who effectively has the right to buy the bond back at a set price at a point in the future. Naturally, borrow- ers almost always exercise that option when rates are low, forcing the bondholder to buy a new bond at the worst possible time. That option has value that gets baked into the price of the bond. How much are those options worth? Wall Street has spent years tweaking imperfect models to answer the question. Most suggest, however, that individuals buy callable bonds at higher valuations (and lower yields) than they’re worth. Even with more-transparent trade data than was once available, most muni managers say they’re still able to sell callable bonds to brokers who deal mostly with retail investors, at prices that woefully undervalue their optionality. Individual Investors Get Lousy Prices Good luck buying or selling your bonds at fair prices. Bonds aren’t like stocks. When they’re traded in small blocks—say, under $ 1 million—pricing is much less attractive than for big buyers. One way to measure that is the bid/ask spread for different size transactions. That spread widens sharply as trades get smaller—and dealers build in bigger price markups—and fund managers have a huge advantage because they are many dealers’ best clients and can trade in big blocks. Bond pricing and yield data have become much more readily available, but pricing can be tricky even across the same bonds traded in blocks of different sizes. The bottom line is that if you want diversification away from Treasuries, building your own portfolio of individual bonds—at fair prices and at a reasonable cost—is a very high mountain to climb. œ Contact Eric Jacobson at eric.jacobson@morningstar.com

It’s an article of faith among many that individual investors should purchase their own bonds rather than buy funds. You can buy Treasuries directly from the government, for example. Once you step away from Treasuries, however, you enter a world dominated by institutions with advan- tages of size and scale and which frankly look to prey on smaller investors to pick up extra profit. As such, there’s a strong case to be made that most investors will have a better experience buying well- run and cost-efficient mutual funds than they will owning most individual bonds. Here’s why: Credit Research Understanding the credit quality of a bond and the price it deserves is a big task. As soon as there’s a hint of credit risk—true for everything beyond Trea- suries in today’s world—bonds trade less predictably. Even though investment-grade bonds, for example, are unlikely to default, knowing what they’re worth is a much different story. Recently, BBB rated corporate bonds yielded more than 2 percentage points more than Treasuries. That’s a snapshot; those “spreads” change from minute to minute and look vastly different today from even a few months ago. And corporate-bond prices can be all over the map. The situation can be even worse for municipals and the research can be that much more difficult to conduct or acquire. The only way to judge whether most bond prices are fair given differences in credit quality is to do, or have access to, rigorous fundamental analysis, real-time bid/ask data for different issuers and qualities (the difference between prices dealers are willing to pay for bonds and those at which they’re willing to sell), and the experience to know how to marry those factors.