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Differences in direct bonds versus bond funds

In my previous article, A journey through the life of a fixed rate bond , I provided an overview of the price and performance history of the Commonwealth Government Security that matured this month, April 2015. This article responds to a reader question about the similarities and differences between investing directly in bonds and buying units in a bond fund or Exchange Traded Fund (ETF).

What happens to the cash on maturity of the bond?

The first difference is that the maturity of a single bond doesn’t bring the life of a bond fund to a close. Other bonds with different maturity dates continue to generate investment returns.

Furthermore, within funds the cash that’s generated when an individual bond matures is reinvested into the market. Although unit trusts are required to pay all interest earnings and realised capital gains to the unit holders as distributions, the proceeds of bond maturities don’t have to be returned to the investors. Instead, they are used to buy new bonds in accordance with the investment policy of the fund.

This isn’t as big a difference as it might first seem, because it’s what direct bond holders often do in practice. Just as people who have a maturing term deposit then roll the proceeds into a new term deposit, so bond investors typically aren’t in the bond market for the limited period of the life of the first bond they invest in. They reinvest into the market and keep their bond portfolio going.

If an investor in a bond fund wants to get some capital back they need to redeem units. Otherwise the manager of the fund will automatically reinvest.

Behaviour of other unitholders

Another difference between owning bonds directly and investing in a fund is that the behaviour of other unitholders can impact some aspects of your investment.

When you own your own portfolio of bonds, you earn interest and only generate any capital gains or losses if you decide to sell some bonds before maturity. If someone else decides to redeem units in a trust in which you are invested, then that may force the manager to sell a bond before it matures. This could generate a capital gain or loss on that security.

This impacts the distributable income that all unit holders in the fund are paid. The main impact is that in addition to interest earnings there will be net realised gains included in all distributions. In turn, this can have tax implications, depending on the tax rate you pay on different sources of income.

There is also the possibility that the bond that has to be sold to fund the other unit holder’s redemption will be sold at a price that is different to the price used in valuing the fund. This could dilute the value of the fund for all unit holders, who have effectively had a small portion of their investment sold at a low price. However, this is usually managed by the fund having a buy-sell spread for transactions in units, based upon the market level of buy-sell spreads for the assets held in the fund. Therefore, it’s only the unit holder who redeems from the fund who experiences losses from this source.

Price movements of bond funds and ETFs

In the article about the April 2015 bond, its price history was summarised. There were times when bonds were in great demand and the price rose compared with times when bonds were unpopular and the price fell. Bond funds will similarly experience rising and falling prices through time, as the price of all securities held within the fund will change as market yields change.

However, a bond fund can be thought of as a family, made up of old bonds, middle aged securities and young ‘uns. That is, it holds a range of securities with a range of different maturity dates. Some will behave like the April 2015 did in its early days – highly sensitive to market yield changes and thus volatile in price. Others will be closer to maturity and behave like the April 2015 has done in the last couple of years – less volatile, with the amortisation towards par value being the dominant feature.  A bond fund’s price fluctuations will reflect the average of all the individual bonds that are held within it.

In Australia, most funds have an average term to maturity of around 3 – 5 years. So they’ll fluctuate like an individual bond with 3 – 5 years to maturity. They will do this all the time, though, rather than eventually shortening towards zero. The reinvestment of maturing bonds across the market keeps the average maturity reasonably steady.

Government bond funds tend to be longer than the average – and thus more volatile in the short term - while corporate bond funds typically have a shorter average term and are less volatile.

Some of these features of bond funds also apply to ETFs, particularly the reinvestment of maturity proceeds and the way they tend to have similar maturity profile over time. One key difference is that the behaviour of other investors in the ETF doesn’t have the same impact because they don’t always force sales or purchases – another investor buys or sells units and the portfolio isn’t affected. Only when investor demand and supply for the ETF are out of balance will bonds have to be traded. This ensures that the value of the ETF reflects the market value of the bonds it holds, rather than the unique demand-supply conditions for the ETF itself.

Investing in a bond fund isn’t exactly the same as investing in individual bonds. However, the most important difference isn’t unique to bond funds. Unit trusts in all asset classes create the same exposure for an investor to the behaviour of other unit holders. For example, an equity fund investor can have the dividend and capital gain mix of their income influenced by other unit holder behaviour in the same way.

This article has been broad and general in nature, because specific bond funds have their own features – actively managed or indexed, for instance. It doesn’t cover all the similarities and differences, but hopefully does provide some helpful information about investing via funds compared with direct bond ownership. Some additional information can be found in another earlier article, The idiot's guide to bond funds.

 

Warren Bird is Executive Director of Uniting Financial Services, a division of the Uniting Church (NSW & ACT). He has 30 years’ experience in fixed income investing, including 16 years as Head of Fixed Interest at Colonial First State. He also serves as an Independent Member of the GESB Investment Committee. This article is general education and does not consider any investor’s personal circumstances.

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5 Comments

Tim Richardson

April 21, 2015

Interesting article. Would it be fair to say that in practice the benefits of direct bond investing are only available to those investors with both significant funds and the investment expertise to construct an appropriate fixed income exposure? (This assumes that they value the benefits of diversification as opposed to concentration in a single security of course.)

Warren Bird

April 17, 2015

Another excellent question, Ralph.

The short answer is that it's complex. Bonds are only one part of the broader set of 'interest rate instruments' that include bank loans, home loans, term deposits, swap transactions among the banks and fund managers, etc, etc.

There are, therefore, decisions being made by literally millions of participants in the global economy that influence the level of interest rates across the financial markets. These decisions are being made for many reasons, not all of which are based on a view of the yield on individual bonds or segments of the bond market. For example, governments usually issue bonds on a regular timetable and don't take a view on whether it's a good yield to borrow at or not. And some investors are compelled to buy bonds whatever the yield - eg banks who need to hold them to meet liquidity ratios required by their regulator.

Thanks for the feedback. I'm glad you enjoy my articles and get something out of them. I'll endeavour to keep up the standard in future pieces that I write.

Ralph Fryda

April 17, 2015

All your bond articles have been v educational and easy to read. Thank you. One question. When bonds are in great demand is this purely a function of yield or are there other factors such as supply and demand irrespective of yield?

Warren Bird

April 17, 2015

There isn't a "typical" fee. There are many different styles of fund and different structures through which the fund is offered.

Wholesale structures have lower fees than retail structures.
Actively managed funds have higher fees than index funds.
Credit funds tend to have higher fees than funds that mainly invest in government bonds.
Funds that invest in global bonds usually have higher fees than those that only invest in Australian assets.

Just check the PDS and other information from the platform provider or fund manager - all fees are disclosed clearly.

The general idea is that the higher the expected return of the specific bond market segments that the fund invests in, the higher is the fee. And the more work the fund manager has to do to assemble and manage the portfolio, the higher is the fee. The fee includes, by the way, a payment for doing all your tax work for you - when you are in a fund, the manager will send you all the information you need at year end to fill in your tax return. This sort of thing is often ignored by people criticising fund manager fees.

Residential MBS are usually structured to be quite low risk in themselves, both because they are strong credits and floating rate so they don't have duration risk. But how they impact a portfolio's risk depends upon what else is in the portfolio and the correlation of the performance of RMBS against the other assets.

ssmith3104

April 17, 2015

It would be useful for you to advise what is the typical management fee charged by bond funds, as that may materially affect the return of the fund vs investors handling their own bond purchases?

The other thing that I would welcome some comments about is the fact that some bond funds hold Residential Mortgage Backed Securities ("RMBS") in addition to ordinary institutional bonds. How does this affect the risk profile of the fund?


 

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