Taxable Bond Investing: Bond Funds or Individual Bonds?

Introduction This paper primarily examines the advantages of bond mutual funds over portfolios of directly held bonds for both institutional and individual investors. First, we review the structural advantages of bond mutual funds, which, compared with separately managed and laddered portfolios of individual bonds, generally provide greater diversification; more regular cash flows that promote stability of portfolio characteristics; better liquidity; and lower transaction and operating costs. Second, we explore the unique advantages of a mutual fund portfolio in three discrete sectors of the taxable fixed income market: corporate bonds, mortgage-backed securities, and U.S. Treasury bonds. The paper’s final section describes the limited situations in which a portfolio of directly held bonds can provide advantages over a mutual fund. We characterize most of these advantages as “control” benefits, and refer to their potentially higher cost as the “control premium.” This control becomes more limited when considering bonds with options, such as corporate and mortgage-backed securities. It is important to note that the main areas in which a mutual fund exhibits advantages over a portfolio of directly held bonds are ones that have a marked impact on a bond portfolio’s risk-andreturn characteristics. For a portfolio of directly held bonds, on the other hand, the control advantage is primarily driven by preference. To help frame some of the concepts discussed in this paper, we begin with a primer on bond pricing. We want to emphasize, first, the common misconception that there is a benefit to receiving principal back at maturity. If that principal is simply reinvested and not used to fund a cash flow, there is no benefit in holding a bond to maturity. Consider that the total return of a laddered separate account with characteristics identical to those of an open-end mutual fund will deviate from the fund’s return only by the transaction and operational cost differentials.