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Rekenthaler Report

3 Reasons to Own Bonds Directly

And three reasons to choose bond funds instead.

Mentioned:

Bond Reason #1: Price
Buying bonds directly costs less than owning actively managed bond funds. Forget the broker’s transaction fee, which, as with stock-trading commissions, has shrunk to almost nothing. The meaningful expenditure comes not from that official charge, but instead from the unstated difference between what the broker paid for the bond and what it charges for its sale. The broker’s profit margin averages about 1% for high-grade corporate bonds.

That amount is roughly double an actively run bond fund’s expense ratio, which runs about 0.50% for the institutional share classes that are currently popular. However, as the bond fund’s expense ratio is levied annually, while the markup on the individual bond is paid only at the time of sale, owning the fund for a decade costs a cumulative 5%, as opposed to 1% for 10-year bonds that are retained until their maturity date.

Admittedly, buying a bond-index fund would be a cheaper option yet, as the largest such funds have expense ratios of less than 0.05%. However, with an annual effective holding cost of 0.10%, the strategy of directly buying corporate bonds (or, for that matter, investment-grade municipals) is competitively priced. Five basis points on a $100,000 investment is $50 per year--not a large amount.

Bond Reason #2: Assurance
Another advantage for direct bonds is that the investor knows how her securities will behave. Their yields are established; their prices will vary, but those changes are immaterial if the investor holds the bonds until they mature; and if the bonds are noncallable, they won’t disappear. In contrast, bond-fund yields fluctuate; the fund’s eventual selling price cannot be known; and if the fund company opts to liquidate or merge the fund, the investor no longer will own what she bought.

(Sometimes, investors believe that directly purchased bonds are riskless, absent credit concerns, because their prices are fixed, while those of bond funds are not. Of course this is an optical illusion, occurring because bond-fund net asset values are widely published, while bond quotes must be obtained. Those who liquidate their bonds learn this lesson the hard way, when the broker’s bid comes in at a discount.)

Bond Reason #3: Initial Payouts
Finally, owning bonds directly likely provides higher upfront yields. All things being equal, direct buyers will pocket their cost advantage, leading to about half a percentage point of extra yield, when compared with the typical actively managed bond fund. In addition, should interest rates decline further, the direct buyer will be locked into higher rates, while the fund will be forced to purchase lower-paying securities. (Of course, the opposite argument applies should interest rates at long last increase.)

Thus, the Dec. 31, 2019 yield on 10-year high-quality corporate bonds, per the Federal Reserve Bank of St. Louis, was 2.79%, while the average 30-day SEC yield for intermediate core and intermediate core-plus bond funds was 2.28%. In this day of low distributions, an extra 51 basis points of yield is worth savoring.

Bond Fund Reason #1: Convenience
Now for the benefits of bond funds. The main reason that people select bond funds over directly held bonds is convenience. Most investors require only a single bond fund, one that owns intermediate-term, high-grade securities. Such funds abound, and with rare exception their performances are pleasantly predictable, hovering each year within a couple of percentage points of each other, as well as of the major bond indexes. Buy one and forget about it.

True, with age comes investment complexity. Retirees who live from their investment income may seek more from their bonds than do younger investors who use bonds as ballast for their equities. Retirees might wish to boost their yield with junk bonds, protect against interest-rate risk by holding more short-term securities, and/or diversify internationally. A single fund may no longer suffice. However, the principle persists: Adding funds is easier than adding bonds.

Bond Fund Reason #2: Avoiding Event Risk
Although a fund may surprise its shareholders by being terminated by its sponsoring fund company, the problem represents an annoyance rather than an outright loss. Of greater concern are credit downgrades, which--unless they come in waves, as during a recession--don’t much affect diversified portfolios, but which can be damaging to those who invest in bonds directly.

Such worries do not greatly trouble highly rated bonds, which generally prove to be “money good,” and they evaporate entirely (crosses fingers!) with U.S. government securities. Thus, I would not wish to exaggerate either the danger, or the benefit provided by funds’ diversification. But over the years, I have received enough phone calls from relatives concerned about their directly held bonds’ issuers to know that bond funds sometimes bring greater peace of mind.

Bond Fund Reason #3: Later Payouts
Perhaps the greatest benefit conferred by bond funds are the commonly cited merits of convenience and diversification, but instead an investment attribute: their habit of growing capital, which ultimately increases their payouts.

Consider first the example of directly held bonds. Counting the effects of the 1% markup, those who invested $100,000 into freshly minted corporate bonds in December 1999 would have received $99,000 worth of securities. That amount would have been returned to them in December 2009, promptly reinvested into new issues worth $98,010, and then redeemed once again in December 2019. A third purchase would provide bonds with a par value of $97,030. With the prevailing 2.79% yield, that amount would make for an annual payout of $2,707.

Meanwhile, each of December 1999’s 10 largest intermediate core and intermediate core-plus funds has grown its capital base over the past two decades. If those who owned those funds spent their income while reinvesting their capital gains distributions, as is the common practice (and which is also comparable to spending the income from directly held bonds, while reinvesting the redemption proceeds), their shares would now be worth more than their beginning values.

As a result, seven of those 10 funds would now deliver higher payouts on that hypothetical December 1999 purchase than would the directly held bond portfolio. For example, Pimco Total Return (PTTRX), which was the largest bond fund in 1999 (and again 10 years later), would have grown that initial $100,000 investment to $142,890 by December 2019, making its payout $3,259--21% above that provided by the directly held bonds.

That said, some bond funds are less conscientious about growing--or even maintaining--their capital base than others. Friday’s column will address that topic.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler has a position in the following securities mentioned above: PTTRX. Find out about Morningstar’s editorial policies.