From the April 2009 issue of Wealth Manager Web • Subscribe!

Bonds Versus Bond Funds

The Barclay iShares Aggregate Bond ETF (AGG) returned 7.9% in 2008, far outpacing the performance of all equity indices. Moreover, this is not a temporary phenomenon. As of early March, bonds had outperformed stocks over the last 30 years, earning a total return of 9.4% versus 8.8% annually for stocks.

In the current risk-averse environment, where sectors of the bond market offer attractive returns, investors and advisors are stepping up their fixed-income allocations, either proactively or by avoiding rebalancing as the value of their equity allocations declines. An important decision they must make is whether to buy individual bonds or bond funds--either as mutual funds or ETFs.

The differences are substantial. Actively managed bond funds can alter maturities, credit qualities and other characteristics of their funds to take advantage of perceived market inefficiencies. Unlike individual bonds, funds are not managed to a fixed maturity date. Buying a fund is like buying bonds and periodically rebalancing to a shifting maturity.

As a result, bond fund performance tends to reflect the overall level of interest rates during the period the fund is held. By contrast, the performance of an individual bond is equal to the yield to maturity at which it was purchased, adjusted only by the reinvestment rate of coupons.

Actively managed bond funds, in general, performed poorly in 2008. The table on the next page shows a sample of five funds widely held by financial advisors, based on data from the Advisor Perspectives universe, which tracks approximately $50 billion of high-net-worth assets managed by registered investment advisors. All five funds are benchmarked against the AGG index; none generated positive returns last year.

Based on data from Morningstar, only 8% of taxable bond funds outperformed the AGG index in 2008 and--more importantly--only 2% of the assets in these funds outperformed this index.

Actively managed bond funds typically have expense ratios of 50 basis points or more. In an efficient market, this forces managers to own riskier bonds in order to equal the performance of a passive portfolio. Owning an actively managed bond fund requires a belief that the market is sufficiently inefficient to allow managers to overcome the expense ratio and outperform a passive portfolio.

This explains the poor performance of some of these funds in 2008. Last year, spreads on corporate bonds widened significantly, particularly toward year-end as the financial crisis deepened. High yield spreads widened by the greatest margin, peaking at nearly 20% over comparable Treasury bonds. Fund managers who reached for higher yields--even in non-junk bonds--faced losses, as yields continued to increase as spreads widened further. In addition, many funds were underexposed to Treasury bonds, which were among the best fixed-income sectors in 2008.

Actively managed bond funds have higher volatility than passive funds, as the table illustrates. Advisors constructing portfolios with optimization tools and databases need to be careful of this. The databases typically use volatility measures based on passive fixed-income indices, and they may not offer proper guidance for translating their recommendations to actively managed funds.

ETFs have the advantage of lower expense ratios. They will religiously track an index, so investors are not betting on whether a fund manager can identify market inefficiencies. But ETFs trade on exchanges, so they have a bid-ask spread, and may also trade at a premium or discount to the underlying index. Similar to actively managed funds, ETFs have a constant maturity; for the AGG, this is about five-and-a-half years.

Individual bonds are preferable in certain cases--for example, when funding a specific obligation with known timing such as college education. Bonds can be purchased directly, without incurring any fees other than the bid-ask spread. Most 529 plans do not offer this option; instead, they offer a range of passive or active bond funds, so individual bonds must be held in a standard account.

In other cases, bond funds clearly make more sense, such as when the risk of default is elevated or the market is illiquid. For example, high yield, foreign and mortgage-backed bonds should be purchased through a fund, whereas government, agency and investment-grade bonds can be held directly.

The choice between bonds and bond funds is less clear in retirement portfolios but generally speaking, individual bonds are preferable. Target date funds use bond funds, but they are ideally managed to a fixed maturity of the target date. In standard stock/bond retirement portfolios, individual bonds can be purchased with maturity dates that correspond to the retirement date.

If the retirement date is more than 30 years away, these bonds must be rolled over. Owning individual bonds requires maintenance (e.g., reinvesting coupons or dealing with bonds that have been called), but this is outweighed by the certainty and reduced risk inherent in an individual bond with top credit quality.

Robert Huebscher is founder and CEO of Advisor Perspectives
(www.advisorperspectives.com), a Web site and newsletter serving the financial advisory industry.

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