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Why Funds Beat Bonds Income Strategist | Christine Benz

sticking with more-liquid bond types, they may not have the time or inclination to conduct the research they need to assemble a well-diversified, high- quality portfolio. That brings me to another hurdle that individual bond- holders face that fundholders do not: the difficulty of building a well-diversified portfolio without a whole lot of money. Bonds are typically issued with face values of $ 1 , 000 , but you may need to buy a block of several bonds to obtain decent pricing. To assemble an individual-bond portfolio that’s reason- ably diversified across market sector, you would need to have a pretty good chunk of change; $ 100 , 000 is often bandied about as the minimum threshold for a portfolio of individual bonds to make sense over a bond fund. By contrast, bond-fund investors can, without a lot of money, readily obtain access to a div- ersified portfolio of bonds—corporate bonds, gov- ernment bonds, asset-backed bonds like mortgage- backed securities, as well as munis—thereby reducing the damage that any one holding can inflict on their overall portfolios. In a related vein, individual bond buyers, particularly those without a lot of money to invest, can face high trading costs when transacting in individual bonds; even investors buying many thousands of dollars’ worth of bonds may face much higher bid-ask spreads than institutional buyers who are trading millions might pay. Thus, even though the mutual fund man- ager levies a management fee, the manager may be able to make up that amount by swinging more- favorable trading costs. Finally, even though holding a bond to maturity can offer some protection from interest-rate hikes, indi- vidual bond buyers are giving something else up: the flexibility to swap into higher-yielding bonds as they become available. Even if interest rates trend up before their bonds mature, they’ll have to stick with their lower-yielding bond until it matures if they want to receive their money back. The ability to easily and efficiently swap into higher-yielding bonds is an advantage bond funds have that holders of indi- vidual bonds do not. œ Contact Christine Benz at christine.benz@morningstar.com

Bond investors often wonder: If you’re concerned about the prospect of rising interest rates crunching your bond fund, why not opt for individual bonds and hold them until maturity? Provided you purchase a bond from a creditworthy issuer, you can simply collect your income stream and then get your prin- cipal back when the bond matures, regardless of the interest-rate climate. Bond-fund holders, by con- trast, won’t necessarily be assured a return of their principal, and the interest they receive from their bond funds could also fluctuate. A period of rising bond yields has the potential to depress the prices of already-existing bonds in a bond fund’s portfolio. That, in a nutshell, is why so many investors have been touting the value of individual bonds versus bond funds lately. Given that interest rates have a lot more room to go up than they can go down at this point, there’s an increased chance that the bonds in a bond portfolio will decline in value over the time that you own a fund. Individual bondholders won’t have to contend with that same issue. If they invest $ 100 , 000 in a bond and the issuer makes good on its debt, the amount they put in is the amount they get back. At the same time, it’s unwise to derive a false sense of security from investing in individual bonds. You often hear professional management touted as a key virtue of mutual funds. That’s because, in addition to evaluating bonds’ interest-rate sensitivities, bond- fund managers also spend time evaluating bond issuers’ creditworthiness as well as other features of the bond. Individual bond buyers may have difficulty finding reliable independent information about less- liquid bond issues from smaller entities and munici- palities, and they may also have trouble evaluating the features that are specific to that particular bond, such as whether it’s callable and how much extra income they should receive if it is. And even if they’re