Bond ETFs versus Individual Bonds
In this brief, we look at the advantages to using bond funds and ETFs relative to building portfolios of individual bonds.
These benefits include generally greater diversification, easier reinvestment of capital and income, and more constant risk characteristics (the most common of which is duration). Bond funds and ETFs also tend to be lower cost for most investors, which should all else equal translate into higher net returns and better performance.
Portfolios of individual bondscan also have advantages, but most of them revolve around control over security specific decisionswithin a portfolio and tend to come with an associated “control premium.” This premium tends to be more pronounced for buyers of corporate bonds and mortgage-backed securities than for government bonds.
Greater diversification
The global investment grade fixed income markets as an asset class plays a key role in investment portfolios as a stabilizing force to diversify riskier investments such as equities.
Access to a well-diversified portfolio of bonds is one of the key advantages to owning a bond mutual fund or ETF, in addition to the increased simplicity and ease of use. Through a single holding, investors can access hundreds if not thousands of bonds that are diversified among issuers, credit quality, and term structure.
Building such a portfolio takes the size and scale provided by a large portfolio such as a mutual fund or ETF.
Costs matter, especially in a low-yield environment
With today’s current low-yield investing environment, the cost of investing matters more than ever. This is especially true for bonds, where yieldsare below their historical averages, meaning costs make up a larger share of returns than they have in the past. All else equal, lower costs should translate into higher net returns and better performance.
Bond funds and ETFs have greater economies of scale than most advisors building portfolios of individual bonds. This should generally translate into lower execution costs. We illustrate this in the figure below where we look at spreads on corporate bond trades by size, which notably decline as trade size increases.
Corporate bond spreads by trade size
Notes: Spreads by trade size are from 2008 to 2010 and taken from The Canadian Fixed Income Market 2014 report. Spread is defined as the log percentage point difference between the trade price and the next unpaired interdealer trade, adjusted for intervening changes in the general bond market, as captured by the exchange-traded fund with ticker LQD (for investment-grade) or JNK (for high yield bonds). TRACE truncates reported trade sizes at $1 million for high-yield bonds and $5 million for investment-grade bonds.
Source: Vanguard calculations, using data from the Ontario Securities Commission (OSC).
Mutual funds and ETFs also tend to have greater bargaining power because they have access to a larger number of dealers and counterparties than smaller investors, which can translate into more favourable pricing relative to smaller investors.
Liquidity and transparency benefits
Bond ETFs can be traded at any time following the market open with full transparency on pricing and what investors are bidding and asking. Data on duration, credit ratings and yield are readily available and accessible for ETFs, making them more transparent and liquid.
Reinvestment of capital and income and portfolio characteristics
Bond funds and ETFs provide more timely investment of initial principal and periodic income cash flow. They also provide more constant risk characteristics (such as portfolio duration) and make liquidations, especially partial liquidations, much easier.
“The control premium”
Individual bonds do provide certain benefits and they mostly revolve around a preference for control over security-specific portfolio decisions. These often result in a “control premium” that is reflected in generally higher transaction costs, lower liquidity and a higher bond portfolio risk. Accordingly, an advisor who chooses this approach must assign a high value to this premium in order to justify the higher costs and additional risks involved.
Low-cost Bond ETFs can add value to client portfolios
Bond mutual funds and ETFs hold a number of advantages over individual bond portfolios in terms of diversification, cost, liquidity, transparency, more constant risk characteristics, and cash flow treatment along with the expertise of an investment management team.
Vanguard bond ETFs can provide the building blocks for low-cost and well-diversified exposure to investment areas important in setting and maintaining your clients’ overall asset allocation strategies.
Important Information
This material is for informational purposes only. This material is not intended to be relied upon as research, investment, or tax advice and is not an implied or express recommendation, offer or solicitation to buy or sell any security or to adopt any particular investment or portfolio strategy. Any views and opinions expressed do not take into account the particular investment objectives, needs, restrictions and circumstances of a specific investor and, thus, should not be used as the basis of any specific investment recommendation. Please consult your financial and/or tax advisor for financial and/or tax information applicable to your specific situation.
All investments, including those that seek to track indexes, are subject to risk, including the possible loss of principal. Diversification does not ensure a profit or protect against a loss in a declining market. While ETFs are designed to be as diversified as the original indexes they seek to track and can provide greater diversification than an individual investor may achieve independently, any given ETF may not be a diversified investment.Investments in bonds are subject to call risk, credit risk, income risk and interest rate risk. Please see the Vanguard ETFs' prospectus for a description of the unique risks applicable to bond investing.
Information, figures and charts are summarized for illustrative purposes only and are subject to change without notice.
While this information has been compiled from sources believed to be reliable, Vanguard Investments Canada Inc. does not guarantee the accuracy, completeness, timeliness or reliability of this information or any results from its use.
This material does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.
In this material, references to "Vanguard" are provided for convenience only and may refer to, where applicable, only The Vanguard Group, Inc., and/or may include its affiliates, including Vanguard Investments Canada Inc.