THE BOND ARGUMENT
Last week’s bond refresher was a preamble to the bond argument we’re having today. Months ago, a client asked this pertinent question: why don’t The Advocates use individual bonds for defensive positions in our allocations? Why insist on using ETFs? It’s a fair question, especially when some advisors insist on the reverse.
Proponents of individual bonds typically cite two reasons for their advice:
Individual bonds can be held to maturity, so while prices may fluctuate, you’ll get your principal back if you wait it out.
They put the individual investor in control, rather than the manager of a bond fund, who may sell bonds that cause capital losses, which would then be passed along to the fund’s investors.
Like so many soundbites, what they’re not saying matters; some of those overlooked tidbits are actually an important part of building a model allocation. Here’s our reasoning:
ETFs spread out risks among fund investors.
ETFs are more liquid because they’re traded on exchanges, not over the counter with more fees and formalities like individual bonds.
It costs more to trade individual bonds. At the moment, Charles Schwab trades ETFs for zero commission.
Fluctuating bond prices affect individual bonds and bond funds alike since ETFs are just composites of individual bonds. No, you can’t hold an ETF “to maturity” and reclaim your principal, but there are reasons that may be less advantageous than people think. More on that next week.
First, if bonds are notoriously safe, how bad could the risks be? While certainly lower risk than stocks, bonds are not risk free and determining how risks could affect you, you alone as the individual bond holder, requires a lot of front-load due diligence.
You’ll need to consider credit, sovereign, and duration risks. Owning ETFs reduces your exposure to potential bankruptcies, volatility, and non-repayment of interest and/or your principal.
Relying on the scores of credit rating agencies should be done with caution. 2008’s financial crisis rightfully sullied their reputation. These and large brokerage houses with significant corporate finance arms are notorious for conflict of interests, reducing their credibility. We prefer to rely on those who are unhindered by conflicts of interest to do this as part of the bond selection for their ETFs.
While ETF liquidity may not be the strongest selling point for someone concerned primarily with principal preservation, remember that people often overestimate the stability of their current circumstances.
The future may hold reasons you’d like sell a bond, then you’ll be dealing with points two and three, which carries significant expense unless you’re trading a huge amount. ETF managers, however, do just that, giving them negotiating power and allowing them to wait for a desirable spread.
We think these are strong reasons to choose ETFS, but some won’t be swayed. It might be that owning an ETF feels more like owning a mutual fund or stock. Seeing a “date and rate” in your brokerage account is a hallmark comfort of bonds.
But low cost, slightly active bond ETFs have too many advantages to ignore. So, we use them for our bond vehicle and choose ones managed by professionals whose only job is to do well with the money you’ve put into their fund, like Dimensional Fund Advisors (DFA). I can’t think of a better way to pursue mutual success.