Investing Basics: Bonds vs Bond Funds
Mr Bond considers the relative merits of bonds and bond funds and considers the likely effect of a rise in interest rates
Bond funds undoubtedly have some advantages, the strongest of which is the ready-made diversification of a pooled investment.
By utilising a fund, the diversification benefits of a hundred or more individual bond holdings can be had at the click of a mouse, with the attendant reduction in transaction costs in comparison to individual bond purchases.
However, bond funds could be argued to be less attractive than holding bonds directly for two reasons.
The first is cost; in a low-yield environment charges levied on managed funds may have a disproportionate impact on the return.
The average investment-grade sterling corporate bond (all maturities) yields around 3% and the popular Invesco Corporate Bond Fund charges 0.55% per annum.
‘a bond fund which trades more like an equity with investors beholden to the future market price’
Skilled fund managers can undoubtedly add value to a portfolio, but 0.55% represents a not insignificant dent in an average yield and initial charges may also be applied.
The second reason is slightly less tangible. When an investor buys a bond, or even a selection of bonds, there is certainty in terms of future cash flows and barring the catastrophic failure of the issuer, the investor can simply wait and the principal sum will be returned to him.
This is not the case with a bond fund which trades more like an equity with investors beholden to the future market price of the instrument in order to realise their cash, thereby adding an additional layer of risk to the financial planning process.
It has been shown that whereas an average corporate bond and a pooled investment may show a high level of correlation over a downside move, the subsequent recovery of the individual bond may be far stronger, particularly where the fixed redemption date of the individual bond pulls it inevitably towards par.
Bond funds and corporate bond funds have been some of the biggest selling retail funds for some time.
When interest rates do begin to rise that is normally seen as good news for savers and less so for ISA savers with popular bond funds.
What Happens to Bond Prices When Interest Rates Rise?
Put simply, bond investors receive a better return than cash savers because they are exposed to greater risk.
The bond market delivers a higher interest rate than cash and when cash interest rates rise the interest rate paid by bonds, called the yield, rises too.
Generally speaking, bond yields move in the opposite direction to bond prices; thus a rise in interest rates means bond prices fall.
‘bond yields move in the opposite direction to bond prices’
However, not all bonds respond to changes in interest in the same way – government debt, or Gilts, are considered as safe as cash and their performance is strongly influenced by interest rates.
Bond funds with a high proportion of sovereign debt may fall more sharply than others in response to rising interest rates.
Conversely, high-yield or sometimes ‘junk’ bonds are less susceptible to interest rate rises and ‘investment grade’ corporate bonds are somewhere in between.
Worth the Wait?
Bonds also respond differently to interest rate rises according to their ‘duration’ or time to maturity.
Bonds are repaid at ‘par’ – i.e. the original amount the issuer borrowed – and so the price of bonds that are due to be repaid imminently are less affected by a rise in interest rates.
However, the price of longer dated products may be more adversely affected because the rise in interest rate effectively erodes the value of future dividends, which make the bond less attractive and the price may fall.
‘Bonds have the admirable characteristic of returning cash to their holders’
In periods of deflation, many bonds could do well because the value of the fixed maturity payment and of the remaining interest instalments will increase in real terms.
This is the opposite to the effect of inflation and junk bonds could suffer in a deflationary environment because of the likelihood that issuers could struggle in the prevailing economic circumstances.
If the issuer goes bust, the bond may be worthless or seriously devalued.
There are always concerns associated with mass-participation and late-stage investors ‘buying at the top’ although with bonds, this problem is perhaps less severe than in equities or other asset classes such as gold.
Bonds have the admirable characteristic of returning cash to their holders, although investors should be wary of holding very long-dated low yielding issues.
The current crop of retail bonds presents a fairly low risk profile in this aspect with yields in the 4-6% zone and maturities around 4-10 years.
The situation is less clear with bond funds, which typically have fairly constant duration. Fund managers may also be tempted to extend duration in order to chase yield.
Another argument that has been made in favour of bond funds in the past is the good liquidity and low entry/exit costs such funds offer.
Investors have been able to benefit from professional securities traders at the fund management groups accessing a deep pool of liquidity within the institutional bond markets although The Telegraph recently reported comments from leading fund manager M&G, warning investors of diminishing liquidity in the underlying bond market.
From the standpoint of the private investor, liquidity means the ability see a transparent price, and execute an order with a reasonably tight bid-offer spread.
The “born on ORB” retail bonds fulfilled this requirement with a typical minimum investment of £2,000; however, despite their popularity with retail investors – with most offers oversubscribed – the number of issues rapidly diminished after a promising start.
At some point, the dysfunctional institutional bond market is likely to impact bond funds, perhaps through frictional costs of investors entering and exiting the funds and on that basis a diversified portfolio of retail bonds offer may offer an increasingly attractive alternative