Once you have decided to invest in a particular asset class, then comes the decision on whether to invest directly or through a fund. Funds are seen as the more ‘hands-off’ approach i.e. you just leave it to the experts to invest, however, that comes with significant additional costs and loss of control. While investing directly keeps the control in your hands, it requires more time to research and make decisions on what to invest in. Which is the better approach?
Prior to moving into the world of direct bond investing in 2013, I was a corporate bond fund manager, so I have some experience from each side of the fence. Like most things in life there is no ‘one size fits all’ approach however if you are well informed then you are better placed to make the right decision for you.
The Case for Funds and Cost Considerations
Funds give smaller investors the ability to achieve a level of diversification that would be impossible to achieve if they were investing directly in bonds. Funds also ensure that you always have a professional overseeing your fixed income investments. This is of value to many who would consider themselves to be relative novices in the asset class.
For larger investors, even those who do consider themselves to be fixed income novices, I think a strong argument can be made for direct investment. As an asset class, fixed income is expected to offer lower and more stable returns than equities. I tend to describe a fixed income portfolio as one that does not need a lot of ‘feeding and watering’. This is especially the case for portfolios that are heavily weighted to investment grade issues. Long term studies point to extremely low default rates in investment grade bonds. Personally I have been involved in a single investment grade default in the last 20 years – a hybrid issued by an Irish Bank. In comparison, a share portfolio is likely to require much more of an active management approach.
Does it really make sense to pay away a meaningful amount of your annual return if there is relatively little requirement for active management? It may do for some investors in an environment where investment grade bonds are yielding >6% however it may be harder to swallow if/when we return to a lower yield environment where the fee can cut meaningfully into the overall yearly return.
Of course there are also costs involved in direct bond ownership however they take the form of an upfront brokerage upon purchase and then a relatively modest annual custody charge. If we take the example of the NAB Tier 2 bond that was issued last week, investors paid a 0.25% facilitation fee and then will incur a custody fee of 0.1%pa until the call, which is the expected maturity, in 2034. Given the coupon of 6.34% direct investors will incur very minimal costs, as a percentage of the bond return, over the life of the bond.
Control and Crisis Management
Aside from the cost benefits I also like the control that direct investment gives investors and I don’t think you need to be an expert to build a solid stable bond portfolio. The higher yield that is in a portfolio the greater the need for diversification, however, I think that the need for diversification in investment grade is as much about managing duration and maturity profiles as it is about managing credit risk. This is an area that your friendly IAM relationship manager can help you with!
Another area where control can be critical is during a crisis. I often advise investors to build portfolios that are ‘crisis ready’. Try to make sure, as much as possible, that you are comfortable with the companies that are held in your portfolio. Not just comfortable during calm economic times but also comfortable when the next storm hits. We don’t need to be able to predict the cause of the next crisis to accept that these conditions come along from time to time. If you hold bonds directly and you are confident in the ability of the issuers in your portfolio to ride out the storm then you have little to worry about. Yes, at times some of the capital price movements might be slightly uncomfortable, but if you are confident in the ability of the company to survive then just hold on while you continue to collect the income. In many ways, this is the time for those sitting on surplus cash to be putting new funds into the market. A lot of long-term bond investors will have stories of picking up bargains in such market conditions.
As someone who managed a bond fund through the GFC, I know that the experience for fund investors in a crisis can be materially different. If you are lucky enough to be in a top quartile performing fund you might be okay but if your fund is underperforming on an absolute, not just relative basis, life can be difficult. Often there will be redemptions as investors pull their money out. Fund managers will run down their cash holdings and may have to start selling assets to satisfy the redemptions. Being a forced seller in a weak market is a particularly unpalatable position to find yourself in. Managers will often sell their strongest positions, the ones where the valuations have held up the best. This makes sense however it results in a deterioration in the overall quality of the portfolio that you are invested in, which isn’t a great position to find yourself in and at some point it might make sense to sell out yourself, almost certainly crystallising a loss in the process.
Certainty and Transparency in Direct Investment
Aside from issues around cost and control I also like the relative certainty of income and return of capital that can be achieved through direct investment. The predictability of the exact timing and amount of income is much more transparent through direct investment than it is in a fund.
Finally, the return of capital at a specific date in the future (the maturity date) is one of the great strengths of a bond investment. This is one that direct investors enjoy and can plan around. Whereas funds are normally invested in a broad range of bonds with issues maturing and funds being reinvested regularly but there is never a point where capital is returned at a predetermined price – 100 (par) as is the case with direct investment.
So, whilst funds can offer a useful entry point into fixed income and provide meaningful diversification for smaller investors, overall my preference is for direct investment. Investing directly in the underlying bonds provides certainty of income and return of capital at maturity on top of meaningful benefits around control and materially lower costs.
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