Individual Bonds or Bond Funds?

Transcription

1 Individual Bonds or Bond Funds? April 2014 When it comes to fixed income investing, advisors can choose between a variety of vehicles to implement bond portfolios. Many choose to construct ladders of individual securities ( laddering generally means to buy a series of individual bonds with staggered maturities, say each year from 1 to 10 years hence, such that bonds mature on a regular basis and provide funds to reinvest into new bonds at prevailing interest rates), while others prefer an all mutual fund or ETF strategy. Others combine these strategies in a plan designed to achieve their clients fixed income goals. There are good reasons for choosing any one of these strategies, depending on your views and objectives. There are a number of determinates which can help steer you in the direction best suited for the needs of your individual client portfolios. Some of the most important include the asset class in question, total dollar amount to invest, need for liquidity, overall cost, and the relative importance of ease of use. In this commentary piece, we will discuss these most common factors and present our views regarding which vehicles may make the most sense under a variety of scenarios. Scenarios where mutual funds or ETFs may make more sense: Asset Class Exposure to certain asset classes may be more appropriately gained through fund investments such as open end funds, closed end funds, or ETFs. High yield bonds, emerging market bonds, convertibles, nonagency mortgage backed securities and asset backed securities are good examples. Choosing appropriate investments in these asset classes require a good deal of specialized skill to effectively navigate and achieve competitive pricing, and hence may best be left to a professional manager. Additionally, mutual funds or ETFs under certain circumstances may provide a higher degree of diversification, which may generally be preferable as investments move deeper into the high yield category. When purchasing individual securities in these sectors, the bid/ask spreads may be significantly wider for an individual investor relative to what a larger institution, mutual fund manager, or ETF could achieve. Conversely, the high quality municipal and taxable bond asset classes can typically be more easily navigated by a wider group of investment professionals, especially with the aid of an outside firm or internal specialist who has expertise in these areas. Also, the bid/ask spreads tend to be narrower relative to the high yield sectors. Amount to Invest

2 Where total dollars committed to a fixed income portfolio is less than perhaps $100,000 to $200,000, mutual fund investments may be more appropriate for reasons such as diversification, ease of use, overall cost, and the ability to buy in very small increments over time. It becomes difficult to effectively ladder and diversify a portfolio if you fall much below these amounts. You can certainly do it by laddering very small increments say, $5000 or $10,000 per bond of higher quality bonds. However, these bid/ask spreads tend to be wider, and many advisors believe the cost/benefit at this point becomes more weighted toward the ease of use and diversification present in a bond fund. Liquidity Needs Liquidity needs may steer all or a portion of fixed income portfolios toward mutual funds or ETFs vs. individual securities. As we will discuss later, we argue a bond ladder constructed with cheap secondary market bonds can be more cost effective over time (especially if there is limited selling activity), thereby leading to potentially higher total absolute returns over time. However, frequent needs for cash that would result in selling large percentages of individual bonds from an account could mitigate, negate, or even reduce the overall returns vis à vis a mutual fund or ETF. For clients with significant ongoing and/or unknown liquidity needs (for whatever reason), it may be advisable to keep a portion in short duration mutual funds, ETFs, or cash, to satisfy these needs. This would also include liquidity needs that may arise from regular monthly or quarterly rebalancing activity. For instance, many advisors reserve a small percentage of the fixed income allocation in a short term bond fund to use for periodic rebalancing, reducing the need to sell individual securities. Of course, there may also be costs associated with withdrawing funds from a mutual fund or ETF, such as commissions or sales charges, so it is advisable that all of these costs are known and considered when developing a strategy to address liquidity needs. Ease of Use Another consideration is the relative importance of ease of use. Generally speaking, it is less difficult to buy and sell shares in mutual funds or ETFs versus individual securities. Building and maintaining portfolios of individual bonds, while it does not have to be all consuming, is more work. We believe there are many benefits that accrue to both advisors and client portfolios which make the work worth it in terms of potential investment results, customization, and firm differentiation. We ll discuss some of these benefits below. Ultimately, it is up to advisor or the individual to determine how the ease of use factor weighs into their decision making, and if this is a suitable strategy for the client. Scenarios where an individual bond ladder may make sense: For the buy and hold investor utilizing a typical asset allocation approach to investing, owning a laddered portfolio of individual bonds in a high quality sector can provide potential benefits relative to owning mutual funds. These possible advantages are most pronounced in both the tax exempt as well as the taxable municipal bond sectors. Here, we ll examine some of the key reasons we believe individual bond ladders may provide a benefit to this group of fixed income investors and advisors.

3 Yield & Return Advantages It has been our contention for a very long time (which we would be pleased to demonstrate) that navigating the secondary market odd lot (piece sizes $100,000 or less) market for individual municipal and taxable municipal bonds may result in a meaningful yield increase relative to the larger, more efficient round lot (piece sizes generally $500,000 or more) market the mutual funds and ETFs must navigate (see Chart 1 below). This is because the majority of the demand in the municipal market is from mutual fund managers and other institutions that seek to put large sums of money (multiple millions of dollars per day) to work at any given time. As one can imagine, navigating the smaller size pieces of odd lots is simply not economical when your need for bonds is so large. This higher degree of demand typically serves to raise prices and lower yields versus the smaller odd lots. This point is counterintuitive as in most every other aspect of life; there is a volume discount. Not so with municipal bonds. Of course, this possible advantage can become a disadvantage if a portfolio of odd lot bonds must be liquidated quickly, relative to larger more liquid round lots. This is why knowledge of an investor s ongoing liquidity needs is an important factor to consider. Chart 1: Chart 1: Bloomberg offering page showing the same CUSIP (IL ST GO, 5% coupon, 1/1/22 final maturity, with a 1/1/16 call at price of 100) being offered by three separate dealers a larger 350M piece at 1.30 yield to call, versus a much smaller 20M piece at 1.69% yield to call, and finally a tiny 5M lot offered at 1.895% yield to call. This is not at all uncommon in the day to day trading of the municipal space. Source: Bloomberg, LP. This comparison is for illustrative purposes only. It is not meant to be indicative of the performance or price of the entire municipal bond market.

4 Additionally, once a bond ladder in constructed, there are no ongoing management fees as with mutual funds and ETFs (there may still be advisory fees paid to an advisor, custodial fees, etc. which may be applicable to all or most of the investments held in an account here we are simply referring to the ongoing management fees in a bond mutual fund or ETF, versus no ongoing fees with an individual bond holding). Even when these fees are small, the combination of these fees with the typically lower yields embedded in fund portfolios (due to the larger round lots as described above) can result in meaningful difference in total return vs. the strategy of investing in a portfolio constructed using the individual bond ladder. We ve illustrated the longer term effects of these management fees on returns, when compared to a bond ladder using a simple example. See the chart 2 below. Chart 2: Investment in Bond Fund(s) Investment in Individual Bond Ladder* $ 1,000,000 $ 1,000,000 $ Fee Exp Ratio $ Fee Exp Ratio Year 1 $ 5, % Year 1 $ 8, % Year 2 $ 5, % Year 2 $ 0.00% Year 3 $ 5, % Year 3 $ % Year 4 $ 5, % Year 4 $ % Year 5 $ 5, % Year 5 $ % Year 6 $ 5, % Year 6 $ % Year 7 $ 5, % Year 7 $ % Year 8 $ 5, % Year 8 $ % Year 9 $ 5, % Year 9 $ % Year 10 $ 5, % Year 10 $ % Year 11 $ 5, % Year 11 $ % Year 12 $ 5, % Year 12 $ % Year 13 $ 5, % Year 13 $ % Year 14 $ 5, % Year 14 $ % Year 15 $ 5, % Year 15 $ % Bond Fund $ 75, % Bond Ladder* $ 20, % *Assume 80 bps spread on building initial portfolio (2 to 12 yr ladder) 95 bps to buy longer bonds at end of the ladder each year Chart 2: The left panel illustrates the fees associated with owning a bond fund charging.50% (50 bps) expense ratio over a 15 year term, initial investment of $1MM, assuming the portfolio value remains at $1MM over the entire term. The right panel illustrates a $1MM individual bond portfolio, constructed as a 2 12 year ladder, with a.8% spread (markup) paid to a broker or brokers where the bonds were purchased. Each year beginning in year 2, the maturing bonds are reinvested at the back end of the ladder with a 95 bps markup, or spread. In this example and under these assumptions, you can see the fees associated with the ladder vs. the mutual fund are considerably less. Importantly, it should be noted that additional fees may be applicable in both instances, such as advisory fees, custodial fees, and so forth. This illustration is simply referring to the ongoing regular management fees associated with a bond mutual fund, versus no similar fees being associated with the individual bonds). Additionally, there

5 are no assumptions being made as to the overall performance of either scenario. This is simply a look at ongoing fees. Source: SP Financial Group of Raymond James Customization & Ability to Potentially Achieve Expected Returns / Income In addition to potential for lower fees and possibly higher returns, the ability to customize a bond portfolio is an important benefit. Investors can target a particular duration, yield, coupon, or type of security. One can lock in a particular yield or income stream for a certain period of time (assuming no defaults), as well as buy certain types of credits which may offer good value in their view, or avoid credits which might be perceived as overpriced or carry too much risk. The ability to customize a portfolio is a benefit and should not be underappreciated. An investor s ability to navigate the individual bond space to capture this type of benefit should of course be weighed against a professional fund manager s ability to invest in these areas. Importantly, most bond mutual funds or ETFs have no fixed yield, income, or defined maturity component (some ETFs such as target date funds may have a final maturity date where the portfolio is liquidated and principal is returned to shareholders, however, these often to not carry fixed income streams, and do have ongoing management fees as described in the prior section). With a portfolio of individual bonds, coupons, maturities, and call dates are nearly always known and remain static (unless a particular investment carries a variable coupon, or a bond defaults). There is no defined maturity date with a fund or most ETFs (some ETFs are target date funds and do carry a stated termination date), and the coupon is rarely a fixed amount. Particularly into a rising rate environment, owning an individual bond with a stated coupon and maturity date can be of particular importance to investors. Within a longer period of rising rates, mutual funds or ETFs could have many years of lower returns or losses. Perhaps most importantly, one cannot predict what those returns will be. Not so with an individual bond that does not default and is held to call date or final maturity thereby achieving the income stream and return expected at purchase. A Note on Diversification While a bond fund can certainly provide more diversification (given that fixed income funds often hold 100 or more holdings), it can be argued that some high quality bond funds, particularly muni bond funds, may be over diversified. Default rates on high quality muni bonds are very low, as shown in Chart 3 below. As you can see, default rates for AAA corporate bonds are approximately the same as for BBB rated municipal bonds. As can be the case, often times high quality credits may trade cheaper than the market for bonds with similar characteristics such as credit quality, coupon, and maturity. For instance, this may be due to a problem in a particular state, whereby one municipality s woes unfairly tarnishes others bonds from the same state. A mutual fund or ETF owning hundreds of issues may not be able to take advantage of these opportunities to the same degree an individual bond buyer could. While Detroit s bankruptcy and ongoing issues surrounding Puerto Rico continue to garner headlines and elevate perceived risk in the municipal space, it should be noted that these stories have been

6 playing out for quite some time. Detroit debt was rated at junk levels for years before the actual bankruptcy, and Puerto Rico s problems have been well known for quite some time as well. As we have also seen, some fund managers owned a large amount of PR debt in their funds, resulting in very poor performance in For these investors, any perceived diversification benefit of owning that particular fund seems to have been misplaced. Both wise and poor investment decisions can be made by individual investors, asset managers, and portfolio managers alike. Chart 3: Chart 3: Moody s Average Cumulative Default Rates, , Municipals vs. Corporates. Source: Nuveen. One important point to keep in mind is just how much the municipal landscape has changed since the credit crisis. Prior to 2007/2008, the investment grade, insured muni space was very homogenous. That is, many munis were insured and carried AAA ratings. Because of this, many investors would simply buy insured bonds paying little attention to the underlying issuer. After many of the muni insurers were downgraded (and some going bankrupt), the municipal bond market quickly evolved into much more of a credit market as compared to any time during recent history. That is to say, munis started trading based more on their underlying credits and fundamentals, with many forms of insurance disregarded completely. The days of novice investors spending 30 seconds looking for a AAA bond and clicking buy are over. While not rocket science, it is important to know what you are buying and what you own. Working with firms that have the tools and expertise to aid in these endeavors can be extremely helpful. If an investor is uncomfortable making these decisions, or is uncomfortable relying on an advisor in the implementation of these portfolios, seeking appropriate mutual fund or ETF investments may be the right choice. Fund Flows and Investor Behavior The rather unique environment of the past four or five years has potentially created some additional benefits for individual bond holders, in our view. For the first time in many years, 2013 fixed income total returns across most investment grade sectors have been negative, due mostly to the Federal

7 Reserve reducing its QE bond purchases and the resulting move higher in intermediate to long term bond yields. In fact, it was the 2 nd worse year for municipal performance since 1994 (see chart 4 below). We believe the natural tendency is for interest rates to drift higher in coming years. Even a range bound to slightly higher yield environment could spell another disappointing year of fixed income returns as compared to what investors have perhaps wrongly become accustomed to, presenting a challenge to advisors as they grapple with managing clients return expectations. Chart 4: Chart 4: MMA Annual 10 year Maturity Municipal Total Returns Source: Municipal Market Advisors Possibly compounding this, it is well known that bond mutual fund and ETF inflows had been extraordinary in the years following the Great Recession. Some of this has reversed in 2013, with almost $65 billion worth of mutual fund outflows during the back half of 2013 for tax exempt muni funds alone (according to the Investment Company Institute). As yields have stabilized in the first quarter of 2014, some of these outflows have reversed and money has begun flowing back into many fixed income sectors. Perhaps some of those prior record inflows will remain invested for quite some time, reflecting an aging and more risk averse population. However, it is likely that an increasing number of investors could become disillusioned with back to back years of low (or negative) fixed income returns and, without the guidance of an advisor, begin to pull money out of these funds and ETFs at a much more rapid pace. This could be very challenging for some fund managers as they attempt to raise capital to meet redemptions, especially in less liquid spaces such as municipal bonds. When a portfolio manager is forced to sell bonds to raise cash it can have an impact in numerous ways, but the main concern centers around one important decision: the choice of security to be sold. The bond chosen for sale typically is the bond with the most liquidity at the highest value that would have

8 the lowest impact on the fund s daily market price. Given the current interest rate environment (fear of rising rates), and the liquidity premium associated with higher quality bonds, that could lead the portfolio manager to sell short maturity bonds of high quality. For the most part, this is the first move considered as both higher quality bonds and shorter maturities have narrower bid/ask spreads which help narrow transaction costs and price headwinds for the fund (a pricing headwind means selling the bonds at prices lower than they are currently priced inside the fund). While that makes sense on its face, there are some very strong negatives associated with this bias. Portfolio quality drift the portfolio begins to drop in credit quality as it will contain less of the pristine credits, given that the portfolio manager has sold these in order to raise the cash Duration drift as more short maturity bonds are sold, the duration (a measurement of interest rate risk) of the portfolio becomes longer. Rising rates with a portfolio of longer maturities could lead to losses for the fund depending on how high rates rise. Another element that should be discussed more thoroughly is liquidity risk. Households (individual investors) dominate the muni market. Either through mutual funds, ETFs, or direct ownership of individual bonds, households hold the vast ownership of muni bonds. In other words, there is limited institutional ownership. The reasons for this are apparent: most institutions do not benefit from the tax advantages of the muni market, as they are pensions, foreign investors, etc. Given that, there can be moments of liquidity events that can take longer for the market to absorb (such as when Meredith Whitney appeared on 60 minutes forecasting hundreds of billions of dollars worth of defaults which led individual investors to panic sell municipal bond holdings). This is much more of a concern for a mutual fund or ETF holder, however. A buy and hold individual bondholder can look past the daily/weekly/monthly swings of their individual bond holdings, assuming this price volatility is not credit induced, and wait for the bonds to reach maturity. Therefore, an individual bondholder can wait out this turmoil as they will not sell their holdings (assuming there is no need to liquidate bonds for cash needs). As for a mutual fund or ETF holder, however, one has to worry about the other guy. In other words, a long term shareholder needs to worry about the other shareholder who sells his shares forcing the portfolio manager to sell a position they would otherwise not want to sell, potentially impacting the portfolio in a variety of adverse ways as listed above. For this reason, as well as the others articulated, it seems best for suitable investors to own a diversified portfolio of high individual bonds, especially into the type of interest rate market most envision, keeping in mind the many factors we have outlined in this article SP Financial Group works closely with fee only investment advisors in the fixed income markets, developing fixed income strategies utilizing individual bond ladders and closed end funds. They can be reached at or spfg@raymondjames.com. For more information, visit

9 Investors should carefully consider the investment objectives, risks, charges and expenses of mutual funds and ETFs before investing. The prospectus contains this and other information about mutual funds and ETFs. The prospectus is available from your financial advisor and should be read carefully before investing. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of SP Financial Group of Raymond James and not necessarily those of RJFS or Raymond James. Investments mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Investing in emerging markets can be riskier than investing in well established foreign markets. High yield bonds are not suitable for all investors. The risk of default may increase due to changes in the issuer's credit quality. Price changes may occur due to changes in interest rates and the liquidity of the bond. When appropriate, these bonds should only comprise a modest portion of your portfolio. Municipal bond interest is not subject to federal income tax but may be subject to AMT, state or local taxes. Income from taxable municipal bonds is subject to federal income taxation; and it may be subject to state and local taxes. Municipal securities typically provide a lower yield than comparably rated taxable investments in consideration of their tax advantaged status. Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. Please consult an income tax professional to assess the impact of holding such securities on your tax liability. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices rise. Diversification and strategic asset allocation do not ensure a profit or protect against a loss. Investments are subject to market risk, including possible loss of principal. The process of rebalancing may carry tax consequences. Every investor s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected. The forgoing is not a recommendation to buy or sell any individual security or any combination of securities. Be sure to contact a qualified professional regarding your particular situation before making any investment or withdrawal decision.