7th Oct

Bonds vs Bond Funds

Bond funds undoubtedly have some advantages, the strongest of which is the ready-made diversification of a pooled investment. By utilising a fund, the diversification benefits of a hundred or more individual bond holdings can be had at the click of a mouse, with the attendant reduction in transaction costs in comparison to individual bond purchases. However, bond funds could be argued to be less attractive than holding bonds directly for two reasons.

The first is cost; in a low-yield environment charges levied on managed funds may have a disproportionate impact on the return. The average investment-grade sterling corporate bond (all maturities) yields around 3% and the popular M&G Corporate Bond Fund charges 1% per annum. Skilled fund managers can undoubtedly add value to a portfolio, but 1% represents a significant dent in an average yield and initial charges may also be applied.

The second reason is slightly less tangible. When an investor buys a bond, or even a selection of bonds, there is certainty in terms of future cash flows and barring the catastrophic failure of the issuer, the investor can simply wait and the principal sum will be returned to him.

This is not the case with a bond fund which trades more like an equity with investors beholden to the future market price of the instrument in order to realise their cash, thereby adding an additional layer of risk to the financial planning process.

It has been shown that whereas an average corporate bond and a pooled investment may show a high level of correlation over a downside move, the subsequent recovery of the individual bond may be far stronger, particularly where the fixed redemption date of the individual bond pulls it inevitably towards par.

Bond funds and corporate bond funds have been the biggest selling retail funds for some time. The Investment Management Association reports that sales of bond funds have doubled this year, with retail sales of £8.1 billion for the first half of 2012.

There are always concerns associated with mass-participation and late-stage investors ‘buying at the top’ although with bonds, this problem is perhaps less severe than in equities or other asset classes such as gold.

Bonds have the admirable characteristic of returning cash to their holders, although investors should be wary of holding very long-dated low yielding issues. The current crop of retail bonds presents a fairly low risk profile in this aspect with yields in the 4-6% zone and maturities around 4-10 years. The situation is less clear with bond funds, which typically have fairly constant duration. Fund managers may also be tempted to extend duration in order to chase yield.

Another argument that has been made in favour of bond funds in the past is the good liquidity and low entry/exit costs such funds offer. Investors have been able to benefit from professional securities traders at the fund management groups accessing a deep pool of liquidity within the institutional bond markets although The Telegraph recently reported comments from leading fund manager M&G, warning investors of diminishing liquidity in the underlying bond market, which appears to be related to the recent FSA enquiry into liquidity concerns in the fixed income market.

From the standpoint of the private investor, liquidity means the ability see a transparent price, and execute an order of perhaps £5,000 to £50,000 on a reasonably tight bid-offer spread. The “born on ORB” retail bonds are fulfilling this requirement. As more bonds are issued, and more participants engage in the market, transparency, depth and turnover are improving which is in sharp contrast to the institutional market where live prices are a rarity.

At some point, this dysfunctional institutional bond market is likely to impact bond funds, perhaps through frictional costs of investors entering and exiting the funds and on that basis a diversified portfolio of retail bonds offer may offer an increasingly attractive alternative.

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