Confusing Investing Safely, With Safely Investing In Bonds

November 2nd, 2012 by

On the popular YAHOO! Finance Show Breakout, Larry Swedroe made the following arguments:

  1. With the exception of retail offering periods, investors are being ripped off when they invest in municipal and corporate bonds.
  2. Investors should therefore invest in bond mutual funds and etfs, many of which are available with very low fees.

 

The video brought up a number of issues that we feel should be discussed

1) The Bad Apple Problem In Bonds

There is a problem with some brokers overcharging for bond trades.  However, the video focused on the worst cases, and not the typical transaction. The problem is not with bonds but with a few bad brokerage firms. A brokerage firm which is willing to gouge you a bond trade will also put you in a bad mutual fund to earn a higher commission.  The question is how can a brokerage firm get away with taking actions which are so blatantly against their client’s interests?

Most brokers don’t legally have a fiduciary responsibility. In plain language, this requires them to put their client’s interests ahead of their own. By law, Registered Investment Advisors (RIAs) have a fiduciary duty. However, your typical stock broker does not.  If you don’t want to be ripped off when buying individual bond issues, work with Registered Investment Advisor or go through a major online broker like Charles Schwab, Fidelity or Zions Direct.  You can learn more about the fiduciary responsibility here.

Larry Swedroe’s firm, Buckingham Asset Management, is a Registered Investment Advisor. They are one of the good guys. However, I don’t like his argument on why to buy bond funds instead of individual bonds.

2) Confusing Performance With Fees

Fees do impact performance. However, high fees don’t necessarily mean worse performance.  Would you rather own a fund with a 2.00% fee that earned 6% post fees, or a fund with a 0.5% fee that earned 5% post fees. Any rational person would choose the fund with the higher performance after fees.  Its not the fees that matter but the return after fees.  To be honest, discussions about fees are really about investment philosophies. Do you believe in passive or active investing?

3) Bonds and Bond Funds Are Fundamentally Different Animals; The Biggest Difference Is Not Costs

In the interview, bond funds and individual bonds are treated as very similar investments. They are basically saying that by substituting bond funds for individual bonds, there is nothing lost. This is not true.

There are two big benefits to holding individual bonds instead of bond funds:

  1. Unless an individual bond defaults, you will get the face value of the bond back at maturity. With the exception of a small segment of funds, this concept does not apply to bond mutual funds. There is no guarantee that you will get back the money that you invest in the fund at some future date.
  2. With time, the impact of interest rate moves become smaller with individual bonds.  This is not true with most types of bond funds.

These concepts are explained in detail in Bond Funds vs. Individual Bonds

Special thanks to the blog, Do-It-Yourself (DIY) Investors, where I originally found the video. This blog has interesting material and I recommend visiting it.

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