Yesterday one of our clients asked us for the cost basis for a corporate bond that had been in her portfolio. It matured last year (2017) and the principal was returned to our client. Her CPA was working on her taxes and needed to know what our client originally paid for the bond – the “cost basis”.
At Springwater, we do not buy individual bonds for our clients. So, I knew that this bond must have transferred in when these folks became clients several years ago. I was able to look at our custodian’s records and determine when the bond was purchased and how much our client paid for it.
Why don’t we buy individual bonds? The answer to this question requires us to consider the differences between, and advantages and disadvantages of, individual bonds versus bond funds.
Let’s start with the costs associated with acquiring a bond. If you are retail investor, you can buy a bond through the “fixed income” desk of a broker dealer. The problem is that you will not be able to determine whether or not the price you receive is fair and reasonable … and it probably won’t be. The bond traders on both sides of the transaction (someone buying on your behalf from someone selling it to you) will negotiate terms that you never see. The bond will be “marked up” or “marked down” to create a spread, so that that both the buyer and seller acting on your behalf can each make a bit of a profit. Because you will likely be buying a relatively small quantity of bonds (perhaps even just one bond), you will be at a disadvantage compared to an institutional investor which transacts in millions (perhaps even in billions) of bond value and can therefore demand more competitive pricing.
Now let’s consider the risks bond investors face. Bonds have interest rate risk. If interest rates change, the value of your bond(s) will change. Specifically, if interest rates go up, bond prices go down. If they go down, bond prices go up. There is also credit risk, which is the possibility that the issuer may default and not be able to make interest payments or redeem the bond at maturity. Also, inflation is a risk, because it can degrade the value of a bond, as it does purchasing power in general.
We know that one of the keys to successful investing is reducing risk, and this can be done through diversification. If you are a typical retail investor with something less than $10 million in your portfolio, it is really not possible to properly diversify your bond holdings across issuers, maturity dates, credit quality and more. But you can own a very well-diversified portfolio using a bond fund.
Investors like bonds, because they provide income. Bonds typically make coupon payments every six months and the original principal invested is returned when the bond matures. The problem with that is most investors like monthly income, and they may not want the principal paid back when the bond matures. Bond funds, however, pay monthly distributions and they reinvest maturing principal payments. They can also accommodate investors who may wish to buy or sell bonds. Bond funds are large enough that the fund manager can maintain the desired characteristics of the fund over time as investors come and go and the overall market environment changes. This is very desirable to the individual investor who could not do so on her own.
The one obvious drawback to bond funds is that investors have to pay an expense for their management. There are various costs associated with the management of a bond fund. However, shrewd investors who do their homework can find bond funds with comparatively very low expense ratios. Springwater uses several bond funds with expense ratios of less than 1/10 of 1%. We think that the benefits of bond funds greatly outweigh the costs.
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