Thursday, February 14, 2013

advantages to using bond funds than individual bonds

advantages to using bond funds than individual bonds : Returns on bonds have been strong and steady over the past couple of years, and investors have flooded cash into bond mutual funds and exchange-traded funds.

From January through November of last year, $346 billion flowed into bond funds and ETFs, while just $11 billion went into stock funds, according to the Wall Street Journal. There’s a bit of a chicken-and-egg situation here: money flows into bonds because of good performance, and good bond performance comes at least partly from high demand from investors.

But some bond experts are starting to question how long the good times can last. Barron’s reported that Loomis Sayles bond fund manager Dan Fuss felt the bond market was overbought and had “very high” risk. CNBC cited a note Bank of America credit strategist Hans Mikkelsen wrote to clients about the risk of “a disorderly rotation out of bonds—characterized by higher interest rates and wider credit spreads.”

Of course no one can know for sure what the future holds, but we do know that bond markets, like stock markets, do change over time, and what works in one market environment may not work in future markets.

Some investors see changing markets as a problem, but for active investors, changing markets can be an opportunity. Active investors can respond to changing markets. If foreign stock markets lag, they can move into better-performing domestic stocks. If growth is out of favor, active investors can turn to value stocks.

The same holds true for fixed-income. If interest rates rise, active fixed-income investors could invest in short-term bonds, which tend to remain fairly stable in rising rate environments, or use floating rate funds, which are more insulated from the negative impact of rising rates.  If credit conditions deteriorated, active investors could move to very high quality bonds, including Treasurys. If bond prices across the board were hit, active investors could even opt to go to cash.

I believe the most effective way for investors to actively manage their portfolios is to use mutual and exchange traded funds. Funds make it easy to move from one area of the market into another. This is especially true of bond funds.

Considering the headwinds facing the bond market, I think there are more advantages to using bond funds than individual bonds. Here are a few reasons why:

1. Diversification: Creating a truly diversified portfolio of individual bonds would require a portfolio upwards of $1 million. But investors can buy a diversified portfolio of bond funds with a few thousand dollars. Another benefit is that bond funds spread out their positions over many individual issues, and this can reduce credit (default) risk.  Most individual bond investors hold less than ten bonds in their portfolio. This may not be very risky when defaults are few and far between, but if the economy falters and more companies start to default on their debt, there could be greater danger in a homemade portfolio of individual bonds.


2. Expert Research: Most investors don’t check on companies’ financial health before buying their bonds. Instead they turn to rating agencies and simply buy a bond rated Aaa by Moody or AAA by Standard and Poor’s. But these ratings may not always be reliable, as the debt crisis of 2008 made painfully apparent. Mutual fund companies really earn their fees by doing the research on companies before they buy their bonds. This is particularly valuable when dealing with lower-quality bonds issued by smaller companies. Often companies don’t pay to have the ratings agencies evaluate their debt, so fund managers turn to their own team of analysts to evaluate risk.

3. Tracking Performance: Assessing the returns of a group of individual bonds can be difficult, because the income is not reinvested and some bond issues may not be readily priced. You’re more likely to pay attention to total return on your bond fund and ETF holdings—and more likely to notice when part of your portfolio isn’t working.

4. Access to Different Areas of the Bond Market: Investors who hold individual bonds don’t usually have access to foreign or emerging market bonds, but bond funds make it easy for investors to invest in niche areas like high yield corporate bonds, and global bonds, particularly those of emerging market governments. These areas are likely to become increasingly important sources of returns for fixed-income investors.

Emerging market economies issue about 10% of the world’s sovereign debt (bonds issued by governments), yet they make up about 40% of the world’s GDP. That puts them (as a group) in a good position to re-pay their debt. Bank loans are another type of security best accessed through mutual funds. Floating-rate funds are pools of bank loans made to companies, and the interest rates on those loans adjust as interest rates change. This can make them potentially appealing in a rising rate environment.

5. Liquidity: Perhaps the most important feature of bond funds versus individual issues is liquidity—the ability to exit a particular asset quickly and efficiently. If volatility increases and all areas of the bond market start to decline, active fixed-income investors can go to cash. By dumping bond funds and moving to the sidelines, fund investors make falling bond prices the fund manager’s problem. It’s much easier to sell shares of a bond fund than to unwind a portfolio of individual bonds. After all, a mutual fund is always required to buy back your shares but no one is required to buy back your individual bond.

These are just some of reasons are why I invest my fixed-income portfolios in funds and ETFs, rather than individual issues. As yields rose in January, I reduced my exposure to intermediate-term bonds in favor of bond funds like PIMCO Income (PONDX) and Osterweis Strategic Income (OSTIX), which have a broader spectrum of fixed-income that they can invest in.

PIMCO Income is weighted toward mortgage-backed and asset-backed securities, but also holds about 13% in emerging market bonds and 5% in floating-rate bank loans.

Osterweis Strategic Income has more credit risk but lower interest-rate risk (due to shorter average duration) than some intermediate-term bond funds. OSTIX also holds about 18% cash because the fund’s managers would rather wait for the bonds they like to reach the prices they perceive to be attractive before buying them. These funds offer a little bit higher yield, and a little lower duration so they offer a little more protection in case interest rates were to rise. (source www.forbes.co )
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