The Battle For Bond Investors' Hearts - Bond Funds Vs. Individual Bonds

by: The Financial Lexicon

I recently came across the Seeking Alpha article, "5 Reasons To Buy Bond Funds And ETFs Instead Of Individual Bonds In 2013 And 2014," which took a stab at answering the question many investors have likely grappled with at one time or another: When buying bonds, should you go with funds or individual bonds?

A few points in the article don't jibe with my individual bond investing experiences and with how the bond market functions. Accordingly, I would like to share the other side of the story by beginning with this quote from the aforementioned article:

"With the bond market likely to move up in the coming year, you want the flexibility to be able to sell whenever and wherever you want. Funds, unlike individual bonds, can be sold for their current value at any time - as opposed to 'safer' individual bonds, which will yield the same thing until maturity."

First, judging by the second sentence of that quote, I assume that "With the bond market likely to move up" refers to yields moving higher, even though the way it is written implies price moving higher. Remember that bonds trade at certain prices, which correspond to certain yields. Therefore, when discussing bonds, if you want to refer to yields moving higher, it is extremely important to specify that.

Second, the author claims that individual bonds cannot be sold for their current value and "will yield the same thing until maturity." That is categorically false. There are vibrant secondary markets for Treasuries (NYSEARCA:IEF) and corporate bonds, and even though the secondary market for municipal bonds is thin, you can submit "bids wanted" to your broker and sell your bonds at whatever the current value is at that time. My portfolio of individual bonds is loaded with bonds I purchased at discounts to their face values. Those bonds were purchased on the secondary market at their "current value" at the time of purchase. This includes both investment grade (NYSEARCA:LQD) and non-investment grade corporate bonds (NYSEARCA:JNK) as well as Treasuries (NYSEARCA:TLT).

Moving along, I would like to address this quote from the article linked above:

"Because smaller bond positions are tougher to unload, you're likely to not get a great market value price for individual bonds that you're trying to sell."

I am still trying to reconcile how the author could have claimed in one sentence that individual bonds can't be sold for their "current value" ("Funds, unlike individual bonds, . . . ") and then turn around and imply that they can be sold in the secondary market (as this second quote implies). Nevertheless, I will also address this point by stating that it is untrue. Dealers certainly will have minimum transaction sizes, but there are scores of one, two, five, and ten bond minimum transaction sizes at "current" market values. I could fill pages of text with the number of Treasuries, corporate bonds, and municipal bonds (NYSEARCA:MUB) that have minimum purchase sizes at 10 bonds or fewer (1 bond = $1,000). On May 3 of this year, I sold just eight Treasury bonds (CUSIP 912810QB7) at a price of 126.65, which was right where the market was trading. I did not have to accept a haircut on my bonds due to the small transaction size. In my experience, the same can be said for corporate bonds (munis are a different story). Of course, there are examples of illiquid securities, just as there are in the stock market. But it is absolutely false to claim that smaller bond positions are tougher to unload and that you are likely to not get a great price for individual bonds you want to sell.

Next, I would like to comment on the author's claim that "Individual bonds are tricky to buy if you're a normal small time investor" and that "Bonds generally need to be purchased in large amounts - many, many thousands of dollars," making it "tricky to diversify yourself." While it may have been historically true that high minimum purchase requirements from dealers and brokers would make it difficult for everyday investors to create a diversified portfolio of individual bonds, that is no longer true. As I referenced earlier, there are countless individual bonds offered with minimum purchase sizes of one to ten bonds. And some major retail brokers have dropped commissions and minimum purchase requirements to the point that putting together a diversified portfolio of individual bonds is a breeze.

The next point of contention is this quote from the aforementioned article:

"Owning individual bonds is tough - you cannot subject yourself to the risk of a bond that could default, as it would ruin a good majority of your portfolio."

First, if you properly diversify (as I've stated can be done), one bond default would not "ruin a good majority of your portfolio." Second, if investors should avoid individual bonds because an issuer might default, then investors should also be sure to avoid individual stocks, which are lower on the capital structure. Among others, I own the corporate bonds of JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), PepsiCo (NYSE:PEP), Johnson & Johnson (NYSE:JNJ), Home Depot (NYSE:HD), Cisco Systems (NASDAQ:CSCO), Berkshire Hathaway (NYSE:BRK.A), AT&T (NYSE:T), and Lockheed Martin (NYSE:LMT). If we are to believe the author of the aforementioned article that I "cannot subject [myself] to the risk of a bond that could default," then the shareholders of each of the companies I just mentioned would also not be prudent in subjecting themselves to the risk of owning the individual stocks. After all, stocks are lower than bonds on the capital structure. If any of those companies default on their bonds, the stocks will be worthless (or nearly worthless).

There is one more quote that needs to be addressed. It doesn't pertain to the bond fund versus individual bonds debate. Instead, it has to do with where yields may be heading in the future:

"As the Fed begins to taper (assuming they eventually get around to it someday), bonds will begin to yield more than they do now."

I do not claim to know exactly where yields will go should the Fed ever get around to tapering, let alone if the Fed ever again hikes the target federal funds rate. But I would like to remind readers that the bond market, just like the stock market, does its best to price in expectations about the future today. In June 2004, when the Fed commenced its last rate-hike cycle, the 10-year Treasury yielded as high as 4.89%. That was up from a low yield of 3.07% in June of 2003. The rise in yield from June 2003 to June 2004 occurred even though the Fed didn't hike the federal funds rate. In June 2006, when the Fed made its last rate hike, to 5.25%, the 10-year Treasury yielded between 4.94% and 5.25%. Despite 425 basis points of rate hikes in just two years, the 10-year Treasury, at one point in June 2006, was yielding only five basis points more than it did at one point in June 2004.

Investors who think the bond market waits for the Fed to act before pricing in changes to policy may be sorely disappointed when tapering finally arrives. I think the levels to which benchmark Treasury yields climbed in September largely, if not fully, priced in Fed tapering. Once the Fed begins to taper, yields could certainly move beyond the September highs. But should that occur, it would likely be because the bond market is attempting to price in the next rate-hike cycle (not just the next rate hike). The bottom line: Be aware that the bond market, like the stock market, does its best to price in things ahead of time.

Last, I don't want readers to think I am completely against investing in bond funds. I recently wrote "The Insider's Guide to Income Investing," a free PDF introducing investors to the world of income investing and discussing the role various asset classes and asset-class categories might play in the income-focused investor's portfolio. In that document, I note the following about bond funds:

"Although I am not a huge fan of bond funds, I can think of two reasons why I might purchase one: First, if I want exposure to a particular part of the bond market but am uncomfortable buying individual bonds in or unable to adequately diversify in that part of the market. Second, if I can purchase a fund with a low/short duration at an attractive price (enough to provide what I consider a margin of safety)."

Those are the two reasons I would consider purchasing a bond fund. One fund that almost meets those criteria and is high on my watch list is the AdvisorShares Peritus High Yield ETF (NYSEARCA:HYLD). Its focus is on single-B-rated corporate bonds, and its duration is 3.28 years. The missing piece of the puzzle is price. I suspect during the next recession (perhaps even sooner), it will trade at a level at which I find the price attractive. In the past, I've owned the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG). At this time, however, HYG is not in my portfolio.

I recognize that each of us is unique in our investment objectives, risk tolerances, and time horizons. If you determine that bond funds are more suitable for your portfolio than individual bonds, then you should certainly purchase bond funds rather than individual bonds. The article linked above provides a thorough list of bond funds for your consideration.

As you work through your bond-buying decision-making process, it is important to have a more complete understanding of the advantages and disadvantages of bond funds and individual bonds. I hope this article will aid you in that endeavor.

Disclosure: I am long CSCO, T, JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am also long the bonds of CSCO, T, JNJ, HD, LMT, WFC, JPM, PEP, and BRK.A. I am long numerous other individual Treasuries and corporate bonds.