4 Reasons to Pick Bond Funds Over Individual Bonds: Vanguard

In addition, diversification means bond funds can take on more credit risk and potentially capture a little higher premium, Tidmore said.

Vanguard acknowledged certain advantages, including potential tax benefits, associated with individual bond ownership.

“Because clients directly own the bonds in (a separately managed account) or a laddered bond portfolio, as their advisor you can use any net losses from individual bond positions for tax purposes to partially offset your client’s earned income or to offset realized capital gain liabilities from other investments. A mutual fund or ETF, on the other hand, cannot pass through realized losses to its shareholders,” the report noted.

“Instead, the fund uses realized losses against realized gains, and carries forward any excess losses to be used against future gains. Although this may defer the pass-through of losses, it provides long-term tax efficiency to the pooled structure. In addition, as the advisor, you have a further option: You can sell your clients’ fund shares to realize a loss where applicable.”

To take advantage of losses in individual bond portfolios or SMAs, however, Vanguard noted that clients will incur transaction costs.

Vanguard also noted that bonds issued outside a client’s home state and those subject to alternative minimum taxes often carry higher yields to maturity. “As a result, your clients may well get higher after-tax returns from a portfolio including such bonds,” and also may benefit from increased diversification, the report said.

With those considerations in mind, “it may be impractical to transition clients from their existing SMA solutions or portfolios of individual bonds into a primarily fund-aligned strategy.”

For advisors that already utilize an SMA or construct their own bond sleeves, a bond fund can serve as a strong complement by providing additional portfolio liquidity to the portfolio and a option for reinvesting periodic cash flows from individual bond holdings or SMAs, Vanguard said.

“The vast majority of advisors who invest for their clients are best served through low-cost bond funds,” Vanguard said, adding that the control that individual bonds offer “comes at a cost.”

Cerulli Associates noted in a recent report that it has seen higher levels of net flows into fixed income mutual funds and ETFs as new products rolled out in recent years. Individual fixed income securities accounted for 6% of advisor-reported product mix last year, according to Cerulli, which also noted that more than 67% of advisors use individual fixed income products.

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