Hiding Behind Individual Bonds

I continue to come across talking heads, advisors and brokers claiming that it is best for their clients to own a small portfolio of individual bonds rather than a bond mutual fund or ETF. Usually this is centered around some nonsense about being better protected against rising interest rates. I’ve already addressed that fallacy so I won’t go into too much detail on that topic, but suffice to say I find it quite erroneous.

My thoughts today are: what is really behind this assertion, and how do financial professionals get away with it?

What’s behind it is relatively simple.  It is the same motivation that leads advisors to promise better-than-market returns through stock picking or market timing or manager selection, despite the overwhelming evidence of the impossible nature of these tasks.  Many advisors and brokers simply feel that they get paid to outperform, so they have to promise that they can outperform (even if they know that they cannot). Picking individual bonds creates the illusion of expertise which can help advisors win new clients. (The biggest irony I’ve seen here is advisors who otherwise adhere to passive investment strategies but assert that they can add value by buying individual bonds).

The beauty of it all is how this charade continues. The same argument that is made to owning individual bonds – “hold them to maturity” – allows brokers and advisors to ignore investment performance, while telling clients to do the same.  Of course this “hold to maturity” refrain is actually just a terrible form of mental accounting. The risk in any diversified investment could be justified by telling people to “hold on,” but it does not mean it helps investors meet their stated goals or provide superior risk-adjusted returns.

This veil of ignorance allows the broker to increase risk in the fixed income portfolio while telling clients “it doesn’t matter, hold them to maturity.”  The broker can take on more interest rate risk and buy lower credits to juice yield, and act as if it is a risk-free proposition. As long as the individual bond doesn’t default, the advisor can justify any performance during the holding period.

Of course, it is not a risk-free proposition.  Even if an individual bond is held to maturity, interest rate risk has opportunity costs.  A 15 year bond paying 4.5% sound great until interest rates rise to 6.5% and the client is told to “hold to maturity.” The investor misses out on the opportunity to earn higher returns because the individual bond is now trading at a loss and s/he is continually told to “hold to maturity.”

And credit risk is real.  Single A rated bonds become BBB rated bonds which can become BB rated bonds and so on.  If the credit quality of a bond falls, so will its market value. The “hold to maturity” refrain will work as long as 1) the bond doesn’t default, 2) the investor doesn’t need money from the portfolio during a down stock market, when s/he would be forced to sell the bond at a lower price or 3) the investor doesn’t mind missing the opportunity to rebalance the portfolio in a period like 2008-2009 when lower-quality bonds fell in tandem with global stocks and higher-quality bonds (and bond funds) held up well and even saw large gains.

In short, owning individual bonds can create a mask over real risks in a fixed income portfolio, allowing advisors and brokers to promise higher yields and better cash flow.  All the while the true risks of rising interest rates and credit quality that come with a well diversified bond mutual fund (or ETF) not only exist but are magnified by the more concentrated positions owned by individual bond investors.

Continue Reading:

Rising Rates: Bonds or Bond Funds?

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