Date: 5/24/2010
Author: John Radtke

Fixed-Income Allocations: How to Evaluate Your Next Move

What are the key distinctions in choosing individual bonds or bond funds for fixed income allocations?

Bond funds and bond ETFs have attracted significant asset flows in the past year. Since January 2010, bond fund inflows are tracking close to a record pace. (1)

Ownership of individual bonds by U.S. investors is also at an all-time high. Retail investment into corporate, municipal, US Treasury and GSE bonds remains robust, even with historic low interest rates. (2)

How are advisers currently allocating fixed income assets? Our firm recently surveyed 2,050 financial advisers regarding fixed income product preferences. We reached out to broad group of advisers representing national and regional broker-dealers, independents and RIAs.(3)

The survey asked advisers if they generally recommend bonds, bond funds or bond ETFs. We found that 42% of advisers recommend primarily individual bonds, while 40% typically recommend bond funds or bond ETFs. The other 18% currently utilize a roughly even mix of bonds, funds and SMAs.

A large percentage of advisers clearly believe that a portfolio of individual bonds can match up to professionally managed bond funds and ETFs. What criteria should advisers and investors consider in making their fixed income allocations and in selecting bonds vs. bond funds?

Diversification:

Adequate diversification in an investment grade bond portfolio can typically be achieved with 10-20 different securities. If the overall portfolio is large enough, individual bonds can be diversified by both credit and maturity. With high yield bonds, 30-40 different securities may be needed for adequate diversification. In the high yield and emerging market sectors, bond funds are often most suitable for individual investors.

Credit Risk:

Credit ratings from S&P, Moody's and Fitch continue to be the standard measurements of credit risk. However, these ratings should not be the sole criteria when diversifying a bond portfolio, whether as individual bonds or bonds funds. As we are seeing in the Eurozone, event risk and potential restructuring of debt are additional factors for consideration.

Income/Defined Maturity:

Is a known cash flow with a stated final maturity a major goal? Both bond funds and individual bonds can deliver regular income, but for predictable income and defined maturities, individual bonds are often the preferred option. With a custom portfolio of bonds, the adviser and investor have control over exactly which bonds are owned at any given time, typically with more predictable tax consequences.

Liquidity/Pricing:

How important is daily or intra-day liquidity? Bond funds have end-of-day liquidity while bond ETFs are even more tradable. Secondary markets for individual bonds vary widely, but price transparency is improving. With TRACE reporting for corporate bonds and MSRB trade data for municipals, advisers have better access to secondary pricing.

Laddering/Interest Rate Risk:

Laddering is a diversification strategy which involves purchasing an assortment of bonds with various maturities. Buying a range of maturities typically reduces a portfolio's exposure to interest rate risk.(4)

While short-term bonds usually offer a higher degree of stability, an investor may sacrifice returns which are often available from longer-term bonds. Conversely, longer term bonds may expose the investor to more volatility, and the possibility of losses if sold prior to maturity.

For example, a ladder may consist of equal amounts of bonds maturing in two, four, six, eight and ten years. In two years, when the first bonds mature, the investor may reinvest the money in a bond with a ten year maturity, thereby maintaining the bond ladder portfolio.

The return on a laddered portfolio is typically higher than a portfolio of only short-term issues. The overall portfolio risk would also be less than a portfolio of only longer-term issues. When compared to buying bonds of a single maturity, the laddered approach offers potential protection against interest rate changes while providing a predictable stream of income.

If interest rates fall, the bonds that mature in two years would have to be reinvested at a lower rate. However, the other bonds in the portfolio would have an above-market return. Alternatively, if interest rates rise, the total portfolio might pay a below-market return, but the maturing bonds can be reinvested in bonds with the higher rate environment

Expenses:

Over an expected portfolio life, a one-time transaction fee for individual bonds can be less expensive than a bond fund's ongoing fees. In the event professional management is not needed (e.g. for higher grade bonds), individual bonds with a single commission may be preferable to a bond fund with potential up-front commissions, annual expenses and management fees.

Investor goals & additional considerations:

What is the investor's expected holding period? What are the investor's age and circumstances? Bond funds can be ideal for retirement accounts, especially when fractional shares and monthly accumulation are appropriate. Individual bonds, however, are often selected in the years prior to and during retirement, or for both taxable and tax-exempt securities. Taxable municipal bonds (Build America Bonds) are also a growing asset class.

With bond funds and ETFs, tax implications vary according to the composition and turnover of the portfolio manager's holdings. There may be unexpected tax liabilities when assets are liquidated in a bond fund.

If individual bonds are chosen, will secondary bonds or new issue bonds be preferable? Tax consequences for bonds purchased at premiums or discounts should be considered, although secondary market bonds often offer relative value. With new issue bond programs designed for individual investors, advisers have many options for creating customized portfolios.

While bond funds and ETFs have many attractive features, individual bonds deserve consideration where suitable.



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