Bond funds vs. Individual bonds

We work with BAM’s Fixed Income Desk and leverage its resources to serve clients’ fixed income needs and goals. BAM’s fixed income advisors build customized ladders and tailor investments for each individual client. This is most commonly done by purchasing individual bonds, which can offer great benefits. There are, however, certain instances where a bond fund is more appropriate for a client to provide proper diversification and minimize risk. The following thresholds have been established for when bond funds should be used:

  • Less than $1 million when buying individual municipal bonds
  • Less than $500,000 when buying taxable products such as CDs, agencies and Treasuries.

There are two main reasons to use bond funds versus individual bonds at these levels, and they are closely tied together: liquidity risk and credit risk. In terms of credit (or default) risk, U.S. Treasury bonds, FDIC-insured CDs and U.S. agency bonds carry either the full backing of the U.S. Treasury or, in the case of U.S. agencies, an implied federal backing. Because of this strong backing, little diversification is needed, but this needs to be balanced against liquidity risk. One difficult aspect of the fixed income market is that smaller pieces of bonds (less than $100,000 in par value), often called odd lots, have large bid-ask spreads, meaning that if an investor owns one and is forced to sell, the pricing would be less than stellar. Based on the typical markup retail investors receive, the sale price would likely be 1–3 percent less than it would be for a larger lot. Because investors will pay a high price for liquidity, we recommend purchasing bond funds where liquidity risk is taken off of the table.

Municipal bonds are not backed by the full faith and credit of the U.S. Treasury. BAM’s strict municipal bond buying parameters weed out riskier credits, but there still is some risk even in high-quality municipal issuers. Because of this, there is a greater need for diversification when purchasing municipal bonds. Therefore, it is BAM’s mandate that no issuer account for more than 10 percent of a client’s fixed income portfolio. Much like Treasuries, agencies and CDs, a steep liquidity penalty is paid when selling smaller, odd-lot pieces of municipal bonds. Due to the balance between liquidity and diversification, a higher threshold is recommended for clients wanting to purchase individual municipal bonds. Again, bond funds will be able to not only provide the diversification but also the liquidity necessary.

Bottom line: It is important for clients to recognize the need to maintain diversification as well as liquidity when constructing bond portfolios. For certain clients, bond funds are effective solutions to balancing these risks. The above guidelines ensure clients are placed in the best possible situation to balance the different risks inherent in the bond market.

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