Many investors have been missing out on the benefits individual corporate bonds offer. According to the Charles Schwab 2016 Annual Report, only 7% of its $2.8 trillion in client assets was held in individual bonds, while 13% was held in cash with the remaining 80% in mutual funds, ETFs, stocks, and other securities. Below are a number of the advantages individual corporate bonds provide so you can determine if they might be right for you.
Higher investment return potential than bond funds and ETFs
Individual investors have a major advantage over bond fund managers since they don’t have to manage billions of dollars and can select the bonds that have the greatest chance to appreciate in value. For an individual investor, perhaps that could mean investing in 10, 20 or 30 different bonds depending on the size of her portfolio. Bond fund managers have to put billions of dollars to work and, therefore, have to invest in hundreds – and, at times, thousands – of bonds. At BondSavvy, we believe investors selecting a smaller number of high-quality bonds can outperform a bond fund that has to select hundreds.
Steve Shaw has shown that a handpicked portfolio of corporate bonds can generate strong returns. For example, Steve generated a 31% annualized return on his high-yield corporate bond investments in 2016. This performance exceeded the 13.9% return of BlackRock's $18.5 billion iShares iBoxx $ Corporate Bond ETF, a leading fixed income exchange-traded fund. Please see calculations of all of Steve's corporate bond investments here.
An effective part of an investor's strategy to address possibility of rising interest rates
If you buy an individual bond, you have an effective tool to help mitigate interest-rate risk: a maturity date. If you hold the bond to maturity, assuming the bond does not default, you will receive the face value of the bond, which enables you to manage interest-rate risk more proactively than when you own a bond fund. When you own a bond fund, you own a basket of securities, all with different interest rates and maturities. Each bond in the fund may react differently to changes in interest rates. This distinction is important if you have a specific time horizon, as investing in individual bonds can help investors ensure a set amount of money is paid back to them when they need it.
Investment returns can compare favorably with those of the stock market
As shown on the this tab, Steve’s high-yield and investment-grade corporate bond investments have achieved 23.0% and 9.3% annualized returns, respectively. These returns compare favorably to stock market returns, all in an investment that has lower risk and, generally, less volatility than stocks.
Lower overall fees than bond mutual funds
From January 2013 through June 2017, Steve has paid $355 in combined commissions, mark-ups and mark-downs, having invested $220,000 in face value of corporate bond investments, executing 18 trades and conducting all of his trades through online brokers. Had that same $220,000 been invested for one year in the BlackRock High Yield Bond Portfolio C Shares, he would have paid 10.5x that amount in fees, or $3,740 given the fund’s 1.70% expense ratio.
Returns your principal at maturity
Many investors invest so they can do something – buy a home, send their kids to college, retire – at a set point in time. It’s easier to do this if you can invest in a security that pays you back at that specific point in time. Corporate bonds are required to repay the bond's face value at the maturity date (unless the bond is called earlier), but bond mutual funds do not have similar obligations. That’s because bond mutual funds don’t have a maturity date and, when their investors need a specific amount of money, they could be out of luck.
Pays a fixed coupon while bond funds and ETFs take the "fixed" out of fixed income
The entire premise of fixed income investing is that you receive a fixed coupon payment twice per year and the return of your principal at maturity. It’s why they call it “fixed income.” Investors receive this when they invest in individual bonds. They don’t receive either in bond funds, which is why we say “bond funds take the 'fixed' out of fixed income."
Individual bond investors are treated more fairly than bond fund investors
In the world of mutual funds, it’s an alphabet soup of investor classes and fees, which typically translates into smaller investors paying a higher percentage
of their investment in fees than larger investors, which is a regressive tax in our book. For example, the BlackRock High Yield Bond Portfolio has
an A, B, B1, C, C1, K, R and an Institutional Class. Those in the B Class paid 1.86% of their investment in fees during the year ended September 30,
2016, while those in the Institutional Class only paid 0.61%. In addition, B Class holders have to pay a fee of up to 4.5% when they sell.
It’s a very different story when investing in individual corporate bonds, as someone investing $5,000 can pay the same price for a bond as someone investing $250,000. In addition, with bid-offer spreads typically between a half to a full point, investors electing to sell prior to maturity can do so without the excessive fees and transaction costs of certain mutual funds.
More transparency than bond funds, as you know exactly what you are investing in
During the Credit Crisis, investors learned why it’s so important to know exactly what’s in their portfolios. When you invest in an individual corporate bond, you know the company, the coupon, the maturity date, the yield…all sorts of relevant information to help you evaluate the risk/return profile of the bond. With bond funds, it’s more of a crapshoot, as very few bond funds only hold corporate bonds. Instead, they hold multiple types of securities that may or may not be what you want to invest in. For example, the BlackRock Core Bond Portfolio contains mortgage-backed securities, municipal bonds, Treasury bonds, CDs, options, and credit default swaps, as well as corporate bonds and other securities.
In addition, many large funds are constantly turning over their holdings, which makes it even harder to know what you are investing in and can reduce fund performance given the significant transaction costs and potentially higher capital gains taxes that can be incurred when trading in and out of high volumes of bonds. For example, the MetWest Total Return Bond Fund, one of the world’s largest actively managed bond funds, reported a portfolio turnover rate of 312.55% for the year ended March 31, 2017.
More investment choice than the stock market
On any given day, people can invest in nearly 10,000 different corporate bonds, approximately double the number of publicly traded stocks. We expect this
enhanced level of investment choice to continue, as corporate bond issuance remains strong and the number of companies going public through initial
public offerings (IPOs) has waned, falling 65% from 2014 to 2016. The number of publicly traded stocks is now at a 35-year low, having decreased 45%
from 1996 to 2015. In contrast, in 2016, companies issued a record $1.5 trillion of corporate bonds, an increase of more than four times from 1996.
In 2016, companies sold nearly eight times more in bonds than they sold in stock. At the end of 2016, there was $8.5 trillion dollars of corporate
bonds outstanding, which is twice the size of the municipal bond market and nearly two-thirds the size of the United States Treasury market.