Window DressingMarch 13, 2014
Source: “Corporate Bond Market Transaction Costs and Transparency,” Edwards, Harris, Piwowar. The Journal of Finance, Volume 62, Issue 3, June 2007.
Are you using individual bonds to differentiate your portfolio offering for affluent investors? Many advisors do, often citing liability matching and taxes as the main justifications for such a strategy. Although, I don’t argue there may be cases where individual bonds make sense for a client, I believe it is important to consider the tradeoffs of using individual bonds vs. a bond mutual fund before making that decision. Below I’ve summarized the key points to consider when deciding between an individual bond and bond mutual fund strategy.
One of the primary benefits of a mutual fund is diversification and the same holds true for a bond mutual fund. A bond mutual fund provides an investor with access to broad diversification across issuers, credit qualities, yield curves and maturities. Most investors—including the affluent—don’t have the capital required to match the diversification available from a mutual fund.
The ability to buy in bulk helps reduce the cost of bond ownership as shown in the chart above. Bond funds buy institutional sized lots and have the ability to find competitive bids and offers, which brings down bid/ask spreads and transaction costs. Because of this, mutual fund managers have a large advantage over individuals purchasing bonds.
When purchasing individual bonds, duration tends to drift downward over time and jump back up as cash flows are reinvested. By pooling investor assets and having more regular cash flows, bond funds are able to purchase a large collection of bonds which can help maintain stable risk characteristics in a more consistent and cost effective way than buying individual bonds.
If an investor liquidates shares of a bond fund, it does not change the risk characteristics of their remaining shares. By contrast, liquidations from an individual bond portfolio require selling a whole bond, which can significantly alter the characteristics of a portfolio.
While individual bonds may offer tax benefits to investors who are trying to minimize federal and state income taxes, it is important to keep in mind that maximizing after-tax returns can be more benefitical than minimizing taxes for the purpose of building long-term wealth. Bonds issued by states other than an investor’s home state and bonds subject to the AMT often carry higher yields to maturity, which can increase after-tax returns for a portfolio and offer diversification benefits.
In your quest to differentiate your services for affluent investors, think twice before settling on individual bonds for the fixed income position of your clients’ portfolios. Individual bond positions may increase the curb appeal of a portfolio for affluent investors, but the appeal may just be window dressing as the tradeoffs can have a significant effect on reducing performance.
Bonds are subject to market and interest rate risk. Bond values will decline as interest rates rise, issuer’s creditworthiness declines, and are subject to availability and changes in price.
Diversification neither assures a profit nor guarantees against loss in a declining market.
LWI Financial Inc. (“Loring Ward”) is not a tax advisor. The information herein is general in nature and should not be considered tax advice. Please consult with a tax professional for additional information.
IRN R 14-088 (Exp 3/16)
Sign up to get email updates with our latest blog posts