Self-Managed Bond Portfolios vs Bond Funds

[AtlasShrugged]

All,

I have another paper for your consideration. This one discusses the merits of creating your own portfolio of individual bonds versus buying bond funds.

I suspect this topic has been previously discussed here (perhaps ad nauseum). This short paper is my take on the subject for those of you who might be interested in an objective analysis. I hope some of you find it useful.

Rick

https://www.dropbox.com/s/3zrz21nn82...02021.pdf?dl=0

[Montecfo]

It is a good analysis. I have maintained that owning individual bonds versus bond funds is mixed bag, with each approach having advantages and disadvantages. That is laid out clearly by the author.

Thank for posting it!

[njhowie]

Good primer for the newbie.

A few personal views were interjected, especially "the myth" claimed to be categorically false (which I disagree with), where a fair amount of space was delegated attempting to prove the view. All you've "proved" is that no matter what price you pay for something, after you buy that price could go up or down. That doesn't prove your view - it just states the obvious. The buy-and-hold-to-maturity bond investor assumes no interest rate risk on his/her investment - he/she has locked in the investment return, and that will not change regardless of what interest rates (i.e. the price of the bond) do between purchase and maturity. The bond "value" day to day shown in the portfolio is completely irrelevant...unless there is potential to sell, and we've already predicated that it is buy and hold to maturity.

But again, for the newbie, a decent primer.

[Midpack]

Thanks, one of the best summary comparisons I’ve ever seen. I’ve thought about going with individual bonds vs bond funds several times but choosing funds well and increased default risk hold me back. It seems like market interest/NAV price risk of bond funds has to impact returns eventually, but their demise has been predicted since 2008-09. There are hold to maturity bond funds that might be a good middle ground (eliminating NAV price risk) - but they’ve never attracted much interest? The last sentence in the paper is probably accurate.

[USGrant1962]

Quote:

Originally Posted by Midpack Thanks, one of the best summary comparisons I’ve ever seen. I’ve thought about going with individual bonds vs bond funds several times but choosing funds well and increased default risk hold me back. It seems like the NAV risk of bond funds has to impact returns eventually, but their demise has been predicted since 2008-09. There are hold to maturity bond funds that might be a good middle ground? The last sentence in the paper is probably accurate.

BulletShares ETFs are hold-to-maturity. Be careful with the short ones though, as they redeem the bonds they roll into cash so the yields drop all through the last year.

[AtlasShrugged]

Quote:

Originally Posted by njhowie Good primer for the newbie. A few personal views were interjected, especially "the myth" claimed to be categorically false (which I disagree with), where a fair amount of space was delegated attempting to prove the view. All you've "proved" is that no matter what price you pay for something, after you buy that price could go up or down. That doesn't prove your view - it just states the obvious. The buy-and-hold-to-maturity bond investor assumes no interest rate risk on his/her investment - he/she has locked in the investment return, and that will not change regardless of what interest rates (i.e. the price of the bond) do between purchase and maturity. The bond "value" day to day shown in the portfolio is completely irrelevant...unless there is potential to sell, and we've already predicated that it is buy and hold to maturity. But again, for the newbie, a decent primer.

You're conflating certainty of results with no interest rate risk. They are two different things.

My proof that individual bonds have interest rate risk speaks for itself. Its not a matter of personal opinion. Its a matter of economic fact.

If you choose not to believe it, then so be it. Many non-newbies make the same mistake. But I feel compelled to correct the record for others.

[OldShooter]

As usual, good work, though I would differ on some of the details.

One main point: I think it is essentially impossible for an individual investor to build and manage a diversified portfolio of individual corporate bonds. For example, I am on an investment committee for a nonprofit where our strategy is to hold corporates to maturity. In one of the accounts we are about 25% in bonds/$600K or so and are nicely diversified and well-managed by the FA. 40 different bond issues bought with careful attention to sector concentrations! I submit that running that kind of diversification as an amateur who also wants to have a life, is close to impossible. The corollary, then is that an amateur wanting a portfolio of individual bonds must choose between being undiversified in corporates or being in govvies, which don't need to be diversified.

[Montecfo]

Quote:

Originally Posted by AtlasShrugged You're conflating certainty of results with no interest rate risk. They are two different things. My proof that individual bonds have interest rate risk speaks for itself. Its not a matter of personal opinion. Its a matter of economic fact. If you choose not to believe it, then so be it. Many non-newbies make the same mistake. But I feel compelled to correct the record for others.

Agree. I thought the analysis did a good job separating the two concepts.

[AtlasShrugged]

Quote:

Originally Posted by OldShooter As usual, good work, though I would differ on some of the details. One main point: I think it is essentially impossible for an individual investor to build and manage a diversified portfolio of individual corporate bonds. For example, I am on an investment committee for a nonprofit where our strategy is to hold corporates to maturity. In one of the accounts we are about 25% in bonds/$600K or so and are nicely diversified and well-managed by the FA. 40 different bond issues bought with careful attention to sector concentrations! I submit that running that kind of diversification as an amateur who also wants to have a life, is close to impossible. The corollary, then is that an amateur wanting a portfolio of individual bonds must choose between being undiversified in corporates or being in govvies, which don't need to be diversified.

We are actually in agreement. Space did not permit a lengthy discussion of corporates, but I agree with you.

[Freedom56]

The article is total nonsense. Buying individual corporate bonds is vastly superior to bond funds. Last March was one of many examples why. I was aggressively buying bonds well below par while bond fund managers were liquidating. Funds buy high and sell low. They are actively buying now at a point when bonds are overpriced but at the next major correction they will be selling many of those same securities. I wait for those panic moments to buy.

[pb4uski]

I think some of Freedom56's point might be valid, but as an individual he has the liberty of selling when he believes bonds are relatively overpriced and sitting on the sidelines when they are overpriced and buying when he believes that bonds are relatively underpriced... a managed bond fund manager has a narrower window of lattitude to do that and an indexed bond fund has no lattitude... in both cases they are paid to be invested in bonds consistent with their investment objectives.

I do like the defined maturity bond funds as an interesting middle-ground between a HTM individual bond portfolio and a bond fund... but I agree with USGrant that their returns are suboptimal in the terminal year because as bonds mature over the year they invest in short term securities until the terminal distribution in December. When I held those ETFs I just sold in January of the terminal year.

These days I prefer CDs to bonds and bond funds and CDs are currently 53% of my portfolio and have a 2.93% weighted average yield.

[Montecfo]

Quote:

Originally Posted by Freedom56 The article is total nonsense. Buying individual corporate bonds is vastly superior to bond funds. Last March was one of many examples why. I was aggressively buying bonds well below par while bond fund managers were liquidating. Funds buy high and sell low. They are actively buying now at a point when bonds are overpriced but at the next major correction they will be selling many of those same securities. I wait for those panic moments to buy.

I don't disagree as far as it goes. But ETFs and CEFs could also be bought at discount in a panic.

But mostly you appear to be describing a trading strategy. Investors are mostly holding over time and that is what the paper appeared to be addressing, not market timing.

[AtlasShrugged]

Trading corporate bonds is a lot like building a meth lab in your basement. You better know what you're doing or it could blow up.

My paper was about bond investing, not bond trading. They are two different things.

[Freedom56]

Quote:

Originally Posted by Montecfo I don't disagree as far as it goes. But ETFs and CEFs could also be bought at discount in a panic. But mostly you appear to be describing a trading strategy. Investors are mostly holding over time and that is what the paper appeared to be addressing, not market timing.

Yes you can buy CEFs at a discount and hold them or sell them when they become overpriced. I hold the vast majority of my bonds to maturity. A change in business fundamentals or questionable accounting practices would be triggers for me me to sell. Passive bond funds/ETFs don't have that trigger and will let holdings depreciate to pennies on the dollar or even zero. I also can avoid perennially loser sectors such as energy, mining, airlines, retail, and concentrate on technology, telecom, biotechnology, and pharma. Very few bond funds can do that.

[Freedom56]

Quote:

Originally Posted by AtlasShrugged Trading corporate bonds is a lot like building a meth lab in your basement. You better know what you're doing or it could blow up. My paper was about bond investing, not bond trading. They are two different things.

I have been managing my fixed income portfolio since 1989 and my holdings are now comfortably into the eight figure territory. There is nothing complex about analyzing a corporate balance sheet, income statement, and business fundamentals. People who buy bond funds are assuming incorrectly that the fund managers are doing that. Passive bond funds are managed by software that buy based on inflows and sell based on outflows. Knowing this weakness allows bond investors like me to buy during those predictable sell-offs often at significant discount to par.

[Freedom56]

Quote:

Originally Posted by pb4uski I think some of Freedom56's point might be valid, but as an individual he has the liberty of selling when he believes bonds are relatively overpriced and sitting on the sidelines when they are overpriced and buying when he believes that bonds are relatively underpriced... a managed bond fund manager has a narrower window of lattitude to do that and an indexed bond fund has no lattitude... in both cases they are paid to be invested in bonds consistent with their investment objectives. I do like the defined maturity bond funds as an interesting middle-ground between a HTM individual bond portfolio and a bond fund... but I agree with USGrant that their returns are suboptimal in the terminal year because as bonds mature over the year they invest in short term securities until the terminal distribution in December. When I held those ETFs I just sold in January of the terminal year. These days I prefer CDs to bonds and bond funds and CDs are currently 53% of my portfolio and have a 2.93% weighted average yield.

March last year was a perfect example of the bond fund "buy high sell low" phenomenon. As you know many exchange traded bonds and preferred stocks dropped as much as 60% due to fund selling. I was at the buying end and you can see my posts during that period. I sold many of those holdings for quick 30-40% gains in a matter of weeks. A bond fund would take almost a decade or more to achieve the same gains. I'll wait patiently for the next sell-off to put new money to work.

[njhowie]

Quote:

Originally Posted by AtlasShrugged You're conflating certainty of results with no interest rate risk. They are two different things. My proof that individual bonds have interest rate risk speaks for itself. Its not a matter of personal opinion. Its a matter of economic fact. If you choose not to believe it, then so be it. Many non-newbies make the same mistake. But I feel compelled to correct the record for others.

By the same token, you can believe what you like, but hopefully others will do their own research and come to their own conclusion on this point.

Quote:

Interest rate risk is the potential for investment losses that result from a change in interest rates.

That potential for loss arises only if the bond may be sold prior to maturity. Again, predicating a hold to maturity, there is no potential for losses resulting from changes in interest rates.

[AtlasShrugged]

Freedom56,

Perhaps you could write a paper on trading corporate bonds and start a new thread. I suspect people with an interest in that topic would appreciate it.

I started this one to help average investors decide which investment approach may be appropriate for them: individual bonds or bond funds.

These are two totally different topics.

[Montecfo]

Quote:

Originally Posted by Freedom56 Passive bond funds are managed by software that buy based on inflows and sell based on outflows. Knowing this weakness allows bond investors like me to buy during those predictable sell-offs often at significant discount to par.

I have made the point a few times that buying bonds through passive vehicles is not the best way to invest in bonds, in my view.

Stated differently, the lowest cost funds may not in fact be the least expensive.

But I believe the author's point was active versus active, so passive doesn't really come into play.

[Freedom56]

Quote:

Originally Posted by AtlasShrugged Freedom56, Perhaps you could write a paper on trading corporate bonds and start a new thread. I suspect people with an interest in that topic would appreciate it. I started this one to help average investors decide which investment approach may be appropriate for them: individual bonds or bond funds. These are two totally different topics.

I follow an extremely conservative investment strategy that may not be right for everyone. My first priority is preservation of capital followed by maximizing yield. There is no magic to buying corporate bonds. Just buy bonds of stable profitable companies in growth sectors with positive cash flow and time your buys when the market is selling off. If you follow this discipline, you can outperform many bond and equity funds. Not everyone is willing to do the research or take the time to actively manage a portfolio.

My point is that bond funds are not superior to buying individual bonds. Even Suze Orman has figured that out and that's not a high bar.