Tuesday, 18 August 2009

Bond Ladder vs Bond Fund? Part 2 - Fund Pluses

This second part of a two part post on ways to hold bonds in a portfolio looks at Bond Funds. Part 1 looked at the Bond Ladder.

Bond Fund
A bond fund holds a collection of bonds. There is a wide variety of investment policies and bond mixes to choose from. Some are passive and indexed, holding a representative sample of the overall market. Some are actively managed attempting to achieve extra returns from trading and anticipating corporate changes or interest rate shifts. Some funds are specialized in government or corporate bonds, some have US or international holdings, others have short duration bonds and still others focus on high yield high risk debt. All charge an annual management fee.

Advantage to the Fund:
  1. Funds are better at diversifying away individual organization credit risk because they hold a much larger number of different bonds than most individual investors could buy. With one purchase it is possible to acquire a large number of bonds to cover the whole Canadian market, like XBB . Even investment grade corporate bonds sometimes run into trouble, are downgraded and the price then takes a big hit. This isn't a problem if it doesn't go into default and the bond is held to maturity but the risk rises. One can acquire a subset that apparently acts as a separate un-correlated asset class - real return bonds, like XRB.
  2. Portfolio rebalancing is easier - in a ladder, if it comes to pass that equities have a bad year and the portfolio is overweight in fixed income, there is a difficult choice of which bond to sell and where to put a hole in the ladder. As well, bond buy-sell minimums might cause an asset allocation overshoot and the buy-sell spread/commission on bonds adds to costs. With a fund, simply buy or sell exactly the amount needed to rebalance.
  3. Purchasing small amounts is more cost effective: Individual bond purchases are lumpy - the minimum bond purchase amount is $5,000 so one needs a fairly hefty sum to even build a ladder. A tiny ladder of five bonds would require $25,000 and that wouldn't be very diversified. The larger the bond purchase the lower the price (implicit commissions are less). Purchasing small amounts is really best done through a fund and for really small amounts (under $1000) at a time, mutual funds are best.
  4. One can buy foreign bonds, like the US dollar iShares Aggregate US market AGG, or even international bonds to further diversify. Read this GlobeInvestor article for a rundown of various US and international alternatives.
  5. Reinvestment of interest is easy with bond mutual funds. ETFs and individual bonds pay out cash interest. If the investor doesn't want the cash to spend it sits idle until a sufficient amount is accumulated to make another purchase at reasonable cost. It should be noted that one type of bond - the stripped residual bond (An excellent brief explanation of stripped bonds is BMOIL's on their website at Strip Coupons and Residual Bonds) - solves this problem but it is a small part of the overall bond market.
  6. Funds take less time to manage - no need for watching credit quality, deciding which new bonds to buy to continue a ladder as bonds mature, the managers are doing it for you.
Where to Find

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