Dave Eldreth:
For investors looking to add fixed income investments to their portfolio, what’s the better approach, individual bonds or bond funds? A Vanguard research paper, A topic of current interest: Bonds or bond funds?, dives into the pros and cons of each type of investment. Today, we have one of the authors of the paper joining us to discuss this important topic.

I’m Dave Eldreth, and welcome to Vanguard’s Investment Commentary Podcast series.

In this month’s episode, which we’re taping on November 20, 2017, we’re going to look at the benefits of both individual bonds and bond funds and discuss what investors should consider when making their decision.

Daren Roberts, an investment analyst with Vanguard Investment Strategy Group, is here to offer some tips for just about everyone, including investors and advisors. Daren, thanks for joining us today.

Daren Roberts: Thanks, Dave, good to be here.

Dave Eldreth: Let’s start by breaking down the considerations when choosing between individual bonds and bond funds.

Daren Roberts: Sure. The main considerations are control, diversification, cost, and, we’ll say broadly speaking, risk management. So this gets into cash-flow treatment and how do you maintain portfolio characteristics.

Dave Eldreth: Okay, so that’s the broad, overall look of it. Can you start by drilling down into the individual bonds?

Daren Roberts: Sure. So I’ll say that [for] investors who consider individual bonds, we find that the main reason is there’s a strong preference to selecting which securities they desire, using individual bonds, investors can build a tailored bond portfolio to meet certain objectives. So, for instance, a high-quality target or exposures to a specific municipality or local issuer or state, for that matter. And another could be just minimizing taxes as an objective.

But this preference for [a] self-directed approach has an implied cost or control premium, and this could be in the form of higher-concentration risks and, in a particular security, wider bid-ask spreads, or higher transaction costs, and potentially less liquidity compared [with] that of a typical bond fund.

Dave Eldreth: Now, does the dynamic for these considerations change at all if I’m considering a muni versus a corporate bond or if, say, I’m a pre-retiree and I have five years to go in my time horizon or if I’m a millennial and I have decades?

Daren Roberts: So, no, that’s a good point. Now in our paper, we reference common bond investments, so municipal bonds, as you mentioned, or corporate bonds or mortgaged-backed securities and Treasury bonds. Now, the considerations, so bond versus bond funds, they’re effectively the same. Some may want to achieve diversification as an objective, so we find more of a risk factor for corporate bonds or municipal bonds just because there’s an added component of credit risk. That’s less of an issue for, say, Treasury bonds. And so I don’t think mutual funds necessarily have an advantage there for building a portfolio. But for the other sort of characteristics, so maintaining the bond characteristics, whether it be average duration or credit quality, I think that’s where the bond funds typically have an advantage, because they get to put money to work in a cost-effective manner.

Dave Eldreth: How much does risk increase when you’re dealing with individual bonds compared [with] bond funds when you can spread out what you’re investing in over the broad market?

Daren Roberts: Well, I think this is where the advantage of having your assets in a bond fund [comes into play]. When you look at different segments of the fixed income universe, so corporates or municipal bonds, there is a component of credit risk associated with that. So if you have most of your assets in any one specific issue, not issuer, but issue, single security, most of your risk is going to be coming from that specific issue.

Now, [in] a bond fund for instance—and we can take any of our municipal funds or even our total bond funds—there are hundreds if not thousands of securities. [In a fund] you have portfolio managers, you have credit analysts, who, whether it be index or active, are looking at the best value associated with credit quality across maturity, duration, a whole host of other bond characteristics that I think the average investor would have to at least have the time, willingness, or ability to do that.

So we think that having professional managers who know those spaces really well—whether they’re specific states or municipalities or localities, or on the corporate side, again, knowing those issuers very well and following them and tracking them and understanding which ones they would overweight or underweight—I think those are, certainly, advantages for using a bond fund.

Dave Eldreth: Regulatory agencies made some changes, and those are going to go into effect next year. Can you talk about what those changes are and what effect you think they will have on the industry?

Daren Roberts: Sure. So in the fall of 2016, the SEC [Securities and Exchange Commission] approved rules that require brokerage firms to disclose to retail investors the pricing of marking up or marking down of corporates, agencies, and municipal bond trades. That’ll be effective in May of 2018. So there’s roughly six months or so for brokerage firms to comply.

Now, we think the impact in the industry, at least what we expect, is greater transparency around not just what is the all-in trading cost that a retail investor is bearing, but [also] what is the market price and the markup or [mark]down in dollars and percent? So that transparency for us is a good thing.

Secondly, I would say that, coupled with declining dealer inventories that we’ve noticed anecdotally, sourcing liquidity for individual retail-size trades, we think, is going to become harder, and this could, in theory, potentially influence the shift for retail investors to moving their assets to separately managed accounts or even, in fact, mutual funds.

Now, our own research has suggested that there is a relationship between the size of a trade and the cost that is borne. We just looked at a five-day period of municipal transactions, and our analysis showed that [for] the average retail trade—and we’ll define that as less than 100,000 [dollars]—investors generally pay more because their trade size [is] in, like, odd lots.

Now, the cost relative to that of a larger-size trade for a high-net-worth investor or, say, an institutional investor, I will say that that’s effectively greater than a million [dollars]. For a retail investor, that cost can be onerous, and that cost actually results in lower yields. So, again, we think the ruling will result in greater transparency, potentially lower transaction costs for retail investors, and, ultimately, we think, that this allows the investor to make what they believe are the appropriate trade-off decisions.

Dave Eldreth: When you say greater transparency, how does that play into the overall narrative where investors are becoming more fee-conscious of what they’re paying for their investments?

Daren Roberts: Right. So there is an assumption that because you’re not paying a commission that there is no added charge to buying a municipal or corporate bond, but, in fact, there is the implicit cost of the markup that a broker is charging an individual retail investor.

So we think that this disclosure and the ability to understand what they’re actually paying for versus what they’re paying up for or paying at a discount [for] helps the investor make a decision as to, “Is that something that is worth the control premium, or is it better to pool your assets into a separately managed account or a bond fund where you’re getting the diversification?” Maybe that’s what they are looking to ultimately do, but they’re just not aware of what their choices are in that matter.

Dave Eldreth: Now, what have you seen from an advisor standpoint? Do advisors tend to put their clients more into individual bonds or do they go the bond fund route?

Daren Roberts: Well, we think advisors will be more apt to put clients into bond funds, and I think the benefits [of that] outweigh the control aspect of being able to pick single-name securities or certain parts of the maturity curve. The benefits related to low-cost, broadly diversified options in different segments of the fixed income universe, I mean, that really puts bond funds at an advantage. And there might be [a] few exceptions for a client, as I mentioned. Certain segments, for instance, like Treasury bonds, may be more conducive to using individual bonds, because there’s no credit risk and they’re liquid and you can buy them directly from the U.S. government. But, ultimately, I think most, if not all, advisors are going to make that investment choice based on the clients’ objectives, their constraints, and unique preferences, just to name a few.

Dave Eldreth: Daren, in the paper, [A topic of current interest: Bonds or bond funds?] you mentioned there’s a common misconception among investors. Can you talk for a few minutes about what you call the principal-at-maturity myth?

Daren Roberts: Sure. The principal-at-maturity myth, this assumes that there’s an economic benefit to holding individual bonds to maturity. Now, the key word here is economic. And we generally hear this when there’s a risk of a higher-interest-rate environment. But irrespective of whether you own individual bonds or a bond fund, you’re still subject to the same interest rate risk, with prices really adjusting to reflect that term structure. So we don’t believe that there’s an economic case, especially if your principal is simply being sold and reinvested in another bond.

Now, there may be a practical benefit in holding individual bonds to maturity. So, for instance, if you have near-term liabilities and those liabilities are predictable, an investor can build a bond ladder where their principal and coupon cash flow can meet those obligations. But that’s not for the average retail investor. We see that, typically, more for the high-net-worth investor, oftentimes more an institutional investor.

And I would add [that] even in form and, actually, in substance, too, the investor is actually creating the same structure as that of a mutual fund, but it’s customized and likely they’re paying higher costs.

Dave Eldreth: Because they’re in more individual bonds compared [with] the bond funds, which—

Daren Roberts: Yes.

Dave Eldreth: Provide the broader exposure.

Daren Roberts: Exactly, so the structure of the mutual fund benefits from scale and, in some ways, better pricing. And so that translates to the investor in a better execution, better efficiency, and presumably more diversified as well.

Dave Eldreth: Great. Well, Daren, thanks for being with us today and sharing your views.

Daren Roberts: Sure. My pleasure.

Dave Eldreth: And thank you for joining us for this Vanguard Investment Commentary Podcast. To learn more about Vanguard’s thoughts on other financial planning topics, check out our website. And be sure to check back with us each month for more insights into the markets and investing. Remember, you can always follow us on Twitter and LinkedIn. Thanks for listening.


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