Debunking the Myth
The inclination of investors to own individual bonds may be a legacy of investing in municipal bond securities, which historically have been sold to retail investors on an issue-by-issue basis.
There may be appropriate times and reasons for individuals to consider building a fixed income allocation through individual bond issues. For instance, an investor may have specific objectives with regard to yield and desire for return of principal. In such cases, it may be more advantageous to invest in individual bonds that could be mapped to their aim for a fixed and relatively predictable annual current income, or a certain maturity date, in order to have the principal investment returned after a prescribed period of time. Individual bonds may also be appropriate in pursuing certain portfolio strategies, like building a laddered bond portfolio.1
That said, there are number of clear reasons that investors might want to use professionally managed pooled vehicles, such as a mutual fund, for investing in fixed income. Chief among them are:
Most investors do not have sufficient knowledge to understand the complexity of each bond’s specific issues, including bond covenants, call dates, analyzing issuer leverage, the bond’s ranking in the issuer’s capital structure, and its level of market liquidity.
Individual investors have limited access to bond markets. Individuals do not typically have the purchasing power of a large institutional bond manager, which helps to obtain best pricing, nor the access to new issues that a professional money manager has.
Constructing a well-diversified fixed income portfolio requires understanding deeply interrelated and complex factors, including the correlation of each bond in the portfolio, structuring the holdings to manage interest rate risk, managing credit risk, and identifying value opportunities—all of which a professional manager with access to robust intellectual resources and tools can better accomplish.
Ongoing monitoring. The economic variables that move bond prices and the individual financial circumstances of each issuer are never static. Most individuals simply do not have the time, resources, and knowledge to continuously monitor their bond investments.
1A laddered bond portfolio is a portfolio of fixed income securities in which each security has a significantly different maturity date. The idea behind purchasing several bonds with different maturity dates rather than one bond with a single maturity date is to attempt to spread interest rate risk, increase liquidity and diversify credit risk.