Paul Meloan – Vested Interest

I plead guilty to spending much more time and energy discussing stocks than bonds. Understanding the role of bonds (a relatively non-volatile asset class when done properly) is a somewhat more abstract subject.  Stocks have higher potential returns and are just sexier to write about.

Index funds exist for bonds the same way they do for stocks, and can be purchased from many different providers like Vanguard and DFA.  Like stock funds, they trade once each day at net asset value (NAV). Depending on where you own them you typically pay a small transaction fee ($10-25). They also have an annual expense ratio, which is what the fund company charges you to run the fund. This is typically 0.25% per year (called ’25 basis points’ in financial lingo) or less.

Traditional brokers have frequently pitched the virtues of owning the individual bonds themselves rather than through a fund. Since most individual investors buy a bond and hold it until maturity, the theory goes “why pay a fund company an annual fee simply to hold my bonds?”

It’s a legitimate question, and there’s a legitimate answer why you should.

Imagine for a moment you like to bake at home, and from time to time you need to buy sugar. When you go to the market you pay the retail price for a 5lb bag and bring it home. Now imagine you are the biggest baker in town, and your bakery distributes 12 tons of baked goods every day. Do you think that baker pays the same price per pound of sugar that our home baker does?

The individual bond investor who buys a $20,000 muni bond through a brokerage account is paying retail.  The person who sold you the bond is marking up the price to make a profit. The bond fund that buys $20 million of bonds per day is paying a much, much smaller mark up on the bonds it purchases. The difference ends up in your pocket.

In an investing world where expected returns on bonds may be less than 3%, this difference can be huge. It can greatly exceed the management fee you’re paying to the fund company. One estimate (pay wall) put the costs of buying a $20,000 muni bond at up to 2%.

Heaven help you if you need to sell an individual bond before maturity. Now you get to sell that bond wholesale, with the mark up going to the dealer in the opposite direction.

In our experience, bond exposure in a portfolio needs to be at several million dollars before using an individual bond strategy is even worth considering. Then we typically employ a separate manager (who charges only a little more than an index fund) to deal with these issues at a cost that’s fair to the investor. All situations are unique, but I have yet to see a situation where investing small amounts in individual bonds began to make any sense.

Paul Meloan is the co-founder and co-managing member of Aegis Wealth Management, LLC, in Bethesda, Maryland USA. Before Aegis Paul was a practicing attorney as well as working in the tax practice of Ernst & Young, LLP.

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