Why Investing In Individual Bonds Makes Sense

Includes: AGG, BND, BOND
by: Bondsquawk, CFA

by Rom Badilla

Many investors try to keep things simple by investing in funds in order to capture returns. While widely used, Mutual Funds or Exchange Traded Funds (ETFs) may not be for everyone, especially investors who are looking for steady income and capital preservation. If you are looking for a solution that is more tailored to your investment needs, then individual bonds are often the better option. To help understand why, let's look at some of the shortcomings inherent to bond funds, and when individual bonds are the better choice for investors.

The Problems with Bond Funds

If you look at some of the heavily traded ETFs, like Vanguard Total Bond Market ETF (NYSEARCA:BND) or iShares Core Total U.S. Bond Market ETF (NYSEARCA:AGG), they-- by design-- attempt to seek performance that corresponds to a major benchmark. For these "passive" funds as well as many others, the Barclays U.S. Aggregate Bond Index is the benchmark of choice since it is generally perceived as a proxy for the Investment Grade bond market. This is the gauge in order to determine the success or failure of that fund. Performance of the fund begins and ends with returns relative to this index.

Problem #1 – Sector Allocation

Due to this mandate, managers will attempt to match their exposure with the benchmark. Because they are married to the index, their objective can be a problem for certain investors. One thing that comes to mind is that an investor who wants exposure to the asset class but may not like certain sectors of the market may choose a general fund anyway. An example in today's market is the Mortgage Backed Securities (MBS) sector.

Yields on the MBS sector are at historical low levels. Relative to Treasuries, they are extremely rich. Don't like MBS? You think that the Federal Reserve's balance sheet expansion of buying a boatload of MBS makes the sector over-valued? The housing recovery is gaining steam and you are worried that a refinancing wave may crush the MBS sector? Too Bad. The benchmark has 20-30% of MBS in the benchmark. Funds that track the Barclays U.S. Aggregate will own these securities. Funds that are actively managed and whose mandate is to outperform the index can own a varying degree of this sector. An investor that wants fixed income returns but wants to avoid MBS will have to deal with it if they own a fund that is benchmarked against this index.

Problem #2 – Market-Weighted Exposure

Another perceived benefit to owning a mutual fund or ETF is diversification. With a simple buy order of a fund, you own a whole portfolio of assets in one shot. The concept is to avoid having significant exposure to a single investment. While this benefit is huge, funds may have more exposure to some bond issuers than others simply because of the construction of the index.

The benchmark is market-weighted in terms of its individual holdings. In other words, the benchmark has more exposure to some individual companies than others. This is determined by the amount of debt a company issues. So the more debt a company issues, the greater the exposure in the index.

According to Barclays' data, General Electric Capital Corp, which is AA-rated, has $83 billion in bonds (which accounts for 2.7% of the Investment Grade Corporate index). A-rated Goldman Sachs sits near the top with $67 billion of bonds outstanding (2.2%) followed by A-rated Bank of America, which has $76 billion (2.5%). Conversely, super safe, AAA-rated Microsoft has less than $10 billion in bonds which accounts for just 0.3%. Funds will tend to lean toward matching the index exposure of individual companies. If one of the larger U.S. banks is downgraded by the ratings agencies and falls in price, the effects will be greater on the fund than a similar price drop for one of the safer but smaller names. This would be mitigated if the portfolio had an equal weight in terms of its individual holdings.

To take this a step further, what if you like or dislike a specific company? What if you think that a company may default on its bonds? While it is hard to predict such things, the fact is that even if there is a possibility of default with a bond, a fund manager is open to owning that bond as long as it is in their benchmark. Given their objective of solely keeping pace with the performance of the benchmark, they are at greater risk in not owning it. This stands to be the case even if the prospects for a company and their ability to pay off its debt may dim.

Problem #3 – Sell Low, Buy High?

A company may have itsratings slashed from Investment Grade to "Junk", which typically results in a decline in price. A fund manager will generally sell that bond after it falls in ratings simply because it is no longer in the Investment Grade index. Of course, this is well after the damage is done to the portfolio. In essence, that manager will monetize that loss to the fund regardless of whether they believe that company can turn things around or not. It is out of their universe so "out of sight, out of mind." This hurts the investor because that loss will be felt on a portfolio level.

Conversely, you may like a High Yield company and the accompanying bonds because they are reducing their debt and may be upgraded to Investment Grade. An individual investor may discover this and own this 'Rising Star' before the upgrade and price gain occurs. An Investment Grade fund manager, on the other hand, will buy it only when the bond enters the realm of its benchmark and well after the price appreciation. While a fund manager may see the same opportunity before it occurs, there is nothing they can do about it because it is not part of their universe.

By investing in individual bonds, you can determine which sectors to have exposure in and which issuers to own. Ultimately, a do-it-yourself investor will be able to manage and control their strategy and portfolio holdings as market conditions change and as opportunities present themselves.

What About Active Funds?

If you don't like the fact that your ETF or mutual fund manager is strictly tied to a benchmark, the easy answer is to invest in active funds like PIMCO's Total Return Fund or ETF equivalent (NYSEARCA:BOND). Actively-managed funds such as these are designed to deviate away from the benchmark to varying degrees with the objective to outperform. While you want to provide some slack in their leash of how they invest, a prudent investor will want to make sure they do not deviate too far. Let's face it. Even one of the largest and savviest players in the bond market is subject to picking the wrong investments. PIMCO's Total Return Fund owned Lehman Brothers before it defaulted in 2008 according to the Wall Street Journal. So for an active fund, the key is keeping tabs on what the manager is doing. Thus, transparency of their money management process is vital to the investor.

The problem is that these funds can be massive in size. With that, some have hundreds and thousands of bonds. Take it from me who has spent the past 15 years running institutional funds and investing in bonds. It is difficult to follow what managers are doing when you are viewing that many bonds.

The issue is that unless you intimately know the process and each bond, it is hard to know what is going on with their strategy. If an investor is going to spend the effort knowing another manager's process, wouldn't it make sense to just use it toward building your own bond portfolio?

Own Individual Bonds to Suit Your Needs

With individual bonds in your portfolio, you know what you own. Sounds simple, right? Can you say the same about what is inside an ETF or mutual fund? As discussed, funds can be difficult to understand if you look underneath the hood. The individual assets these funds own may not be that complicated but their investment process can be. This process can conflict with the objectives and risk tolerance of some investors. By choosing to own individual bonds, you will have greater control that could lead to better performance. Furthermore, you should have a better grasp of your investments and where you stand today in reaching your goals.

If you want to learn how to build your own portfolio of bonds, visit our website, Bondsquawk.com, for more strategies and insights. Another great resource on learning about bonds, visit our friends at Learnbonds.com.

Special thanks to Dave Waring in assisting with this article.