Many investors have overlooked owning individual corporate bonds in spite of their many advantages over other investments.
|Advantages of Individual Corporate Bonds vs.|
|Bond Funds||Stocks||Muni Bonds|
|Higher potential after-tax returns|
|Easier to buy & sell|
|No recurring fees|
|Pays fixed coupon|
|Returns principal at maturity|
vs. Bond Funds
Investors in individual corporate bonds have a key advantage over funds: the ability to be selective and find bonds that can appreciate in value and achieve strong returns. Many bonds trade at a discount to par value, which is where BondSavvy focuses its investment recommendations. Since bond funds are so big and have to own so many bonds, they often own bonds priced at significant premiums to par value with little upside opportunity.
vs. Muni Bonds
Many investors in high tax brackets favor muni bonds because they believe they can achieve higher after-tax returns. When BondSavvy recommends corporate bonds, we are focused on maximizing capital appreciation, which, given the more favorable tax treatment of capital gains vs. interest income, can help achieve higher after-tax returns than munis.
We believe it is easier to identify capital appreciation opportunities in corporate bonds given the superior and more frequent financial disclosures required of companies compared to muni bond issuers.
A key advantage individual corporate bonds have over stocks is that they can achieve strong returns and limit your downside. Most corporate bonds trade in a range between 80 and 125. While some bonds do fall below 80, it is rare. Being able to quantify your downside is an important tool for individual bond investors.
vs. Bond Funds
The first part of 2018 has been difficult for many corporate bond investors, with the popular iShares LQD ETF down 5% through May 16. The problem with owning an indexed fund such as LQD is that you have limited ability to improve performance since the bonds in the fund are replicating an index and are not the bonds that can perform best in this market.
When we make investment recommendations, we advise subscribers to make an initial investment and then, over time, add to that position based on the performance of the company and the pricing of the company's bonds. This helps limit our downside as, in the case of falling prices, we continue to buy in at lower prices that, over time, will help our investments achieve strong returns.
We have also recommended a number of non-investment-grade corporate bonds that have performed well since these bonds are typically not sensitive to interest rates. Individual corporate bond investors have greater flexibility and can adjust their portfolios accordingly to take advantage of, and to protect against, market conditions.
vs. Muni Bonds
Individual corporate bonds trade in a robust marketplace where typically 6 to 9 dealers are posting live bid-offer quotes. It is a technology-enabled marketplace with reasonable bid-ask spreads as shown in the following chart where 75% of investment-grade corporate bonds had a bid-ask spread of 1 point or less.
Bid-Ask Spread Distribution for 4,534 Investment-Grade Corporate Bonds*
Corporate bonds are in stark contrast to muni bonds, as munis do not have a live bid-offer market with multiple dealers quoting. Instead there is one dealer quoting only on the offer side, which makes it hard to know the price at which you can sell the bonds.
This superior liquidity makes it easier to buy and sell individual corporate bonds compared to munis.
* From search conducted on Fidelity.com on April 23, 2018.
vs. Bond Funds
Bond funds are still larger than ETFs, which means most fund investors still can't buy and sell intraday. The corporate bond market is dynamic and always changing. There are earnings announcements, mergers, and news that investors must digest real time. Executing an individual corporate bond trade takes seconds and you can trade any time during the day. Owning individual corporate bonds enables you to act more quickly -- and precisely -- to events that impact your corporate bond investments.
vs. Bond Funds
When you own individual corporate bonds, you know exactly what you are investing in. You know the issuer, the yield, the maturity date, the price, and many other pieces of information that help investors assess a bond's risk and return. Bond funds are essentially derivatives that contain hundreds of bonds that can change every day. There are very few 'pure play' corporate bond funds. Rather, most bond funds own an assortment of securities, including Treasury bonds, corporate bonds, municipal bonds, common stocks, preferred stocks, and cash.
When investors build their portfolios, it is crucially important to know the specific securities that are in it. For example, the popular iShares Core U.S. Aggregate Bond ETF (AGG) often holds more than 10% of its portfolio in cash. An investment in this bond ETF immediately over-allocates investors to cash. If you own individual corporate bonds, you can ensure you are investing in what you want.
vs. Muni Bonds
Investors are always learning more about corporate bond issuers through quarterly earnings releases, investor presentations, executive interviews, and other SEC filings. This enables investors to quickly assess the financial health of a company and invest accordingly. Municipal bond issuers, on the other hand, have far less stringent reporting requirements, and often report their financials once per year.
In addition, the pricing of corporate bonds is more transparent than that of municipal bonds, as corporate bonds enjoy a robust, two-sided market with between six to nine dealers providing live-and-executable bid-offer quotes. Municipal bonds do not have multiple dealers providing live quotes, which can make assessing the value of a municipal bond more difficult.
When investors own individual corporate bonds, they pay a transaction fee to buy and a transaction fee to sell. On platforms such as Fidelity.com,
this fee is $1 per bond. Therefore, if you own a portfolio of 100 bonds and sell it after three years, your total fees paid would have been $200.
This represents significant savings to bond funds, many of which charge 1% management fees. Had an investor opted to put $100,000 into a bond
fund charging 1% during this three-year period, he would have paid $3,000 in fees compared to the $200 paid for the individual corporate bond investor.
Had this investor subscribed to BondSavvy for $395 per year, his total fees paid, including the $200 transaction fees, would have been $1,385, less than half what a 1% management fee fund investor would pay.
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."
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.
On any given day, people can invest in nearly 9,000 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 67% from 1999 to 2017. The number of publicly traded stocks is at a 35-year low, having decreased 45% from
1996 to 2015. In contrast, in 2017, companies issued a record $1.6 trillion of corporate bonds, an increase of 3.5x from 1997. In 2017, companies sold
over eight times more in bonds than they sold in stock. At the end of 2017, there was approximately $8.5 trillion 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.