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Portfolio > Economy & Markets > Fixed Income

4 Reasons to Pick Bond Funds Over Individual Bonds: Vanguard

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What You Need to Know

  • Holding a bond to maturity offers little benefit over bond funds, Vanguard said.
  • A bond fund operates similarly to a bond ladder but with lower costs, according to the asset manager.
  • However, owning individual bonds has tax advantages.

Buying individual bonds may offer advisors and clients greater control than investing in bond funds, but low-cost funds have four major advantages — greater return opportunities, lower transaction expenses, better diversification and higher liquidity, according to a recent report from Vanguard.

It’s a myth that holding an individual bond to maturity will help investors avoid losses when interest rates rise, providing a benefit over bond funds, the mutual fund and ETF giant said. Holding a bond to maturity offers little to no financial benefit to advisors or clients, Vanguard said.

A laddered strategy, in which a client buys individual bonds with staggered maturity dates, often involves reinvesting cash flows, as bond funds also do, the firm noted.

“Both portfolios operate in a similar way, but the laddered portfolio is likely to incur greater trading costs and have less diversification,” the report said.

Bond funds consistently reinvest at the current rate, which tends to smooth out the lumpiness, Chris Tidmore, senior manager of Vanguard’s Investment Advisory Research Center, told ThinkAdvisor on Friday.

“Given the higher risks and costs associated with portfolios of individual bonds, and the time they take to manage, most advisors are better served by low-cost mutual funds and ETFs,” the report said.

“Particularly in the case of municipal and corporate bonds (versus U.S. Treasurys) it is likely that only clients with enough resources to build a portfolio of comparable scale to a mutual fund or ETF can afford to pay the costs for these control advantages,” it said.

Lower Transaction Costs

Larger trade sizes are much less expensive in the corporate and muni space, which generally translates into lower costs for bond funds, Tidmore explained.

Vanguard’s report included a chart showing that in the municipal bond market, the spread for a retail trade under $100,000 per bond was consistently higher on average than spreads on institutional trades.

Between January 2019 and April 2021, the effective spread for transactions with a par value between $25,001 and $100,000 averaged 56.4 basis points, while transactions with a par value of over $1 million averaged 20.2 bps.

“This differential translates to lower total return for clients who are not able to transact at scale,” the report said, suggesting that large institutions also have access to more bonds. ”In the end, higher spreads translate into lower returns.”

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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