Capital Perspectives: Bonds and bond funds – Six vs half a dozen
There has been a lot written recently about how owning bonds directly is superior to owning them via a mutual or exchange-traded fund.
Generally speaking, those subscribing to this point of view are outsmarting their common sense.
To frame the argument, let’s consider a simple example involving the stock of Microsoft, currently the world’s most valuable company. If your entire portfolio is comprised of shares of Microsoft and that company’s share price goes down by 10 percent, your portfolio will also decrease by 10 percent, obviously. Ignoring fees for the moment, if your entire portfolio is comprised of a fund, which itself invests solely in Microsoft, a 10 percent decline in the share price of Microsoft is also worth 10 percent off your portfolio.
The straightforwardness of the above example is lost on many when bonds are involved. It should not be. If you insert a 10-year Treasury Note for Microsoft into the above paragraph the same outcome holds.
However, knowing bonds eventually mature at par, many think that a 10 percent price decline in a bond held individually is superior to that incurred by a bond fund which is fully invested in an identical bond because the individual security will eventually mature at par value while the fund has no maturity date.
An investor holding this point of view overlooks that the identical bond held within the fund will also mature, with the maturity proceeds paid to the fund, the fund they own. Presumably, the fund will then invest those proceeds in a new bond, just as would an investor in individual bonds aiming to maintain their exposure to the asset class.
Of course, in reality, bond funds do not simply own a single bond issue, but many issues of differing maturities and credit qualities. However, this does not change the six in one hand, half a dozen in the other argument made herein. For just as we should be agnostic between a portfolio fully invested in Microsoft directly or indirectly via a fund, so too should we between a stock portfolio allocated evenly between Microsoft and Apple shares or a fund with an identical allocation. There is not a different set of rules for bonds.
So, as with choosing between individual stocks or stock funds, the choice between owning bonds directly or via a fund should come down mostly to measuring the ease of diversification which can be achieved by a fund against the offsetting imposition of a management fee. Different investors will weigh these pros and cons differently.
Since the topics are so closely related, it is worth making a passing mention here that the fallacy of mark-to-market losses in directly held, high-credit quality bonds being inconsequential is codified in financial accounting standards via the ability to account for some bonds on a held-to-maturity basis. It is my opinion that the ability to account for a meaningful portion of their bank’s securities portfolio in this way led the management team at Silicon Valley Bank to the delusion they were taking much less risk than they actually were.
This delusion famously ended last spring.
Chas Craig is principal at C.E.C. Wealth Management (www.cecwm.com).