From the Desk of the Investment Policy Committee:
April 2018 – Individual Bonds vs. Bond Funds and Bond Exchange Traded Funds
There are many ways of investing in fixed income to properly diversify a portfolio. Often, bond mutual funds or exchange traded funds (ETF’s) are used instead of individual bonds. While bond mutual funds have some benefits, their risks can outweigh the rewards.
Bond funds and ETF’s offer diversification which helps mitigate the risk of default on a debt that may arise from a borrower failing to make required payments, i.e. credit risk. However, with U.S. treasury bonds, and FDIC insured certificates of deposit (CD’s) there is less need for diversification because there is minimal credit risk. A similar point can be made with high quality corporate and municipal bonds.
Bond funds and ETF’s also charge annual recurring expenses, which can significantly reduce the net return of the portfolio, especially in a low interest rate environment such as we have currently. While trading costs of individual bonds might be high, purchasing bonds through Missouri Trust & Investment Company affords you the advantage of institutional pricing where mark-ups are eliminated or greatly reduced, resulting in savings for you.
A high quality portfolio of individual U.S. treasuries, CD’s, corporate and/or municipal bonds allows you to be far more certain what your performance returns will be. Each bond has a specific coupon to track when payments will be made and a specific maturity date when your principal is returned to you. This compares with bond mutual funds and ETF’s, which have interest payments that can vary month to month, and no maturity date upon which you would expect the return of your investment.
Current Market Environment
Our reading on the current shape of the yield curve suggests that there is minimal yield advantage to investing in longer dated bonds. Recently, short-term interest rates have been moving up much faster than longer-term rates. At this time, a 3-year treasury note yields 2.48% and a 5-year CD yields 2.95% (see current rates here). These rates compare with a 10-year treasury that yields 2.83% (see current rates here). As a result, we don’t see any great yield and income advantage to locking up money in longer-term bonds at this time. This is even more significant when compared to investing in bond funds or ETF’s that have no final maturity date.
Finally, if interest rates continue to gradually increase, we will have the opportunity to reinvest the short dated bonds as they mature into higher yielding bonds in the future. Ultimately, in a rising interest rate environment, we will look to invest longer term and extend out the maturity ladders to capture more attractive interest rates and cash flow.