The Most Important Consideration In How You Buy Bonds

There have been a couple of interesting articles on SA recently regarding the use of pooled products (ETFs and CEFs) and individual bonds (I,II) in investors' portfolios. While I did not agree entirely with either write-up, I think the authors of both of these articles make salient points and arguments about how one should allocate to the fixed income space. However, I think both pieces failed to detail the most important consideration when one pits funds versus individual issues in a bond allocation strategy - and that's the value of the fees one pays to own pooled products.

Justify What You Are Paying For

If you look at the variety of funds available on the open market, you'll find drastic differences. If you buy Vanguard's Total Bond Market ETF (BND), you will pay only one tenth of one percent (.10%) per annum in fees, while if you buy a leveraged closed-end fund you could be paying upwards of two percent (2.0%) every year. Given dramatic differences in cost of ETF/CEF ownership in the low rate world we currently invest in, one should be aware of how much money is being invisibly sucked out of your pocket each year. While I won't say that professional management is never worth paying for in the fixed income universe, you should certainly justify the need to pay for it.

When you buy individual bonds, your cost is up front and pretty well defined. While brokers will pocket some off the top (spread) and will charge commissions and potentially other fees on both buys and sells, there is typically no ongoing cost to own bonds. Depending on how much you invest and your holding period, owning individual issues can keep a tremendous amount of money in your pocket over the long haul.

For purposes of this article, we will assume that an investor has sufficient monies to purchase and diversify adequately amongst individual issues. Certainly one simple justification for utilizing pooled products is a low amount of investable assets. Another would be lack of interest, time, or expertise ! in managing a bucket of bond positions.

While actual cost is certainly something to key in on, I believe that it must be taken in context, relative to the types of bonds being considered and the yield of the fund at the time of purchase. For some there may be value in paying an elevated management fee to own high-yield or emerging market sovereign bonds, while little value in paying nominal expense to own lower yielding investment grade corporate paper. Products with higher fees that outperform their peers on a regular basis may also be worth considering paying up for, versus "cheaper" funds that don't get the job done.

How Much Are You Really Paying?

The following chart takes a comparative look at some widely held ETFs/CEFs holding different types of bonds. The objective is to visualize not only how much these products cost, but also to break down the percent of total yield depleted by management fees. I define total yield as current annualized yield plus net fees - in other words the yield of the fund if there were no management fees attached. The funds we will examine are aforementioned BND, iShares 20+ Treasury Bond (TLT), iShares High-Yield Corporate (HYG), Nuveen Municipal Value (NUV), Eaton Vance Limited Duration (EVV) and Alliance Bernstein Global High-Yield (AWF).

Fund	Yield	Fee	Fee as % of Yield
BND	2.54%	.10%	3.79%
TLT	3.15%	.15%	4.54%
HYG	5.82%	.50%	7.79%
EVV	7.80%	1.60%	17.02%
NUV	4.86%	.55%	10.16%
AWF	7.98%	.98%	10.93%

The two funds with the lowest fees, index fund BND and Treasury tracker TLT, eat away a substantially less percentage of yield as compared to the other funds. The Eaton Van! ce fund, ! which is around 30% levered, eats away the most yield by a large margin. I think there's many ways to look at this information, but frankly because all these funds have different average weighted maturities, durations, strategies and credit profiles, there's really no easy way to create an apples to apples comparison.

Consequently, one must judge independently, fund by fund, if there is value in owning products that eat away at your yield year after year or not. Value is in the eye of the beholder. Personally, I think it would take a lot of justification to own some of the bond ETFs/CEFs out there and perhaps a couple in the above chart. But unlike most market pundits that cast a dangerous wholesale light on bond and bond fund ownership, I have no such opinion. The low rate environment has dampened the total return opportunity for bonds, but for thoughtful investors, they still possess portfolio value in my opinion. Nonetheless there is capital and opportunity cost risk in a rising rate environment that should not be overlooked nor discounted.

In my personal portfolio, I have built a laddered portfolio of investment grade bonds that easily exceeds the yield of BND with no fees. Therefore, I see no value in owning something like BND or TLT. However, I do own AWF, as I have no interest in examining credit worthiness of higher-yielding entities. While the management fee eats away 10% of the yield I might otherwise be able to purchase by investing in individual issues, I consider it money well spent. This fund provides instant diversification and mitigates my having to investigate high-yield credit around the globe, which, while perhaps doable, would be too time consuming and research intensive for my liking.

Conclusion

Bonds serve many purposes. For some they provide balance, diversification and protection. For others they provide needed income. Investors with capital conservation as a main or fringe goal should keep maturities short and closely monitor credit quality in my opinion,! especial! ly if the global macroeconomic picture dampens. Pure income investors should build ladders that create a "portfolio apathetic" positioning relative to interest rate volatility. When it comes to selecting specific fixed income positions, there is a wide variety of strategy involved, however when it comes to how you buy bonds, ongoing cost and the value of that cost should be your most important consideration.

Source: The Most Important Consideration In How You Buy Bonds

Disclosure: I am long AWF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.