A Case for Owning Investment Grade Individual Bonds as Opposed to Similar Style Bond Funds

Friday, October 1, 2010

 

Over the years we have consistently counseled our institutional and high net worth clients to own individual bonds rather than bond funds when there are adequate funds to properly diversify their fixed income exposure. This recommendation involves holdings of what we refer to as “traditional investment grade bonds” (i.e. treasuries, agencies, investment grade corporate, and agency backed mortgage backed securities). Other sectors of the fixed income markets which have a higher risk/return profile including high yield, distressed debt, emerging market debt, non dollar denominated debt, etc. may be more applicable to bond funds unless the size of the portfolio is substantial ($100MM or more).
 
With interest rates remaining near historical lows across the yield curve, potential upward price movement of traditional bonds is very limited. Over the last 20 years the 5 year treasuries have traded in a range of 8.55% to a low of 1.17% with a current yield of 1.52%. The average yield during this 20 year period for the 5 year treasury issue was 4.90%.
 
If over the next 3 to 5 years the yield on this 5 year treasury were to return to its historic average of 4.90%, the price of a 5 year treasury bond would decline by approximately 14%. Conversely if rates in this time period were to actually fall from the current rate of 1.52% to 1.00% (unlikely scenario) the price would increase by 2.3%. Therefore the risk/reward tradeoff for bond prices from current interest rate levels seems to not favor bond investors, especially bond fund investors.
 
By buying individual bonds which have and trade to a stated maturity investors enjoy certain advantages over holding bond funds. These include the ability to manage tax issues (if applicable) taking gains or losses if available and needed for tax management issues. In addition individual bonds have known returns since if held to maturity the purchase yield becomes the known return. Not only will the return be known but a stated maturity allows an investor to know when and how much they will be receiving at maturity (assuming no defaults). Investors can then plan potential cash flow needs, changes in asset allocation can be made with the knowledge of when funds are available to switch asset classes, etc.
 
It should be noted that an individually invested bond portfolio which maintains a relatively constant duration or average maturity will experience the same total returns on their portfolio as a similarly constructed bond fund. Except for the advantages noted above (assume fees are similar) there is no real difference in their likely returns; nevertheless the predictable value of individual bonds versus the unknown future value of bond funds is a significant advantage and tilts the discussion significantly in our opinion towards individual bonds.
 
Another potential issue affecting both corporate bonds and bond funds involves the potential of wider credit spreads in coming years. This would be a further drag (negative performance) on bonds and bond funds especially if this occurred in a rising rate/ falling bond price environment. A news story such as today’s story of KKR (largest LBO firm in the world) in talks to acquire DelMonte Foods Inc. is an early sign that event risk may be returning to the fixed income markets. If so knowledgeable investors will demand wider spreads (lower prices/higher yields) to hold corporate bonds further eroding returns as mentioned above.
 
Ancora’s conclusions:
 
1. The 30 year bull market in fixed income securities is coming to an end, even though it may be a few years until a bear market begins (higher yields/lower prices) any further positive performance by traditional bonds is limited.
2. As such from an asset allocation position, maintaining lower relative exposure to traditional bonds is our current allocation recommendation
3. If some bonds are desired or needed in a portfolio, minimizing the length of the duration of the portfolio structure is recommended.
4. In addition maintaining some exposure to shorter duration structures such as floating rate bonds, inflation linked bonds, hybrid fixed to floating rate bonds; non dollar dominated bonds, etc. are recommended sectors for bond allocations.
5. We believe the eventual shift to a bear market will be a function of the fiscal challenges in the US and in our opinion the lack of success we may have in solving these difficult fiscal challenges.
 
 
James Bernard is an Investment Advisor Representative of Ancora Advisor LLC an SEC Registered Investment Advisor. He is also a Registered Representative and Registered Principal of Ancora Securities, Inc. (Member FINRA/SIPC).