20
It’s an article of faith among many that individual
investors should purchase their own bonds rather
than buy funds. You can buy Treasuries directly from
the government, for example.
Once you step away from Treasuries, however, you
enter a world dominated by institutions with advan-
tages of size and scale and which frankly look to
prey on smaller investors to pick up extra profit. As
such, there’s a strong case to be made that most
investors will have a better experience buying well-
run and cost-efficient mutual funds than they will
owning most individual bonds. Here’s why:
Credit Research
Understanding the credit quality of a bond and the
price it deserves is a big task. As soon as there’s a
hint of credit risk—true for everything beyond Trea-
suries in today’s world—bonds trade less predictably.
Even though investment-grade bonds, for example,
are unlikely to default, knowing what they’re worth
is a much different story.
Recently,
BBB
rated corporate bonds yielded more
than
2
percentage points more than Treasuries. That’s
a snapshot; those “spreads” change from minute
to minute and look vastly different today from even a
few months ago. And corporate-bond prices can be
all over the map. The situation can be even worse for
municipals and the research can be that much more
difficult to conduct or acquire. The only way to judge
whether most bond prices are fair given differences
in credit quality is to do, or have access to, rigorous
fundamental analysis, real-time bid/ask data for
different issuers and qualities (the difference between
prices dealers are willing to pay for bonds and those
at which they’re willing to sell), and the experience to
know how to marry those factors.
Call Risk
Deciding what to do when bonds are called is impor-
tant, but judging the value of their call options is
critical. When you purchase a callable bond (including
mortgage securities, which are much more compli-
cated), you are also “selling” an option to the borrower,
who effectively has the right to buy the bond back
at a set price at a point in the future. Naturally, borrow-
ers almost always exercise that option when rates
are low, forcing the bondholder to buy a new bond at
the worst possible time.
That option has value that gets baked into the price of
the bond. How much are those options worth? Wall
Street has spent years tweaking imperfect models to
answer the question. Most suggest, however, that
individuals buy callable bonds at higher valuations
(and lower yields) than they’re worth. Even with
more-transparent trade data than was once available,
most muni managers say they’re still able to sell
callable bonds to brokers who deal mostly with retail
investors, at prices that woefully undervalue
their optionality.
Individual Investors Get Lousy Prices
Good luck buying or selling your bonds at fair prices.
Bonds aren’t like stocks. When they’re traded in
small blocks—say, under $
1
million—pricing is much
less attractive than for big buyers.
One way to measure that is the bid/ask spread for
different size transactions. That spread widens
sharply as trades get smaller—and dealers build in
bigger price markups—and fund managers have
a huge advantage because they are many dealers’
best clients and can trade in big blocks.
Bond pricing and yield data have become much more
readily available, but pricing can be tricky even across
the same bonds traded in blocks of different sizes.
The bottom line is that if you want diversification
away from Treasuries, building your own portfolio of
individual bonds—at fair prices and at a reasonable
cost—is a very high mountain to climb.
œ
Contact Eric Jacobson at
Bond Funds Are Way Better
Than Bonds
Income Strategist
|
Eric Jacobson
