How You Absolutely, Positively, Unequivocally, Know it's Better to Own Bonds Directly*
Updated: Jun 23, 2021
There are many different ways to have bond exposure, but if you don't own the individual bond directly, you might not be getting the most you can out of bonds.
When you buy a bond and hold it to maturity your holding period return is certain, it's called the Yield to Maturity (YTM).
A bond fund makes a bond act like a stock and the uncertainty of the future returns leads to a gnawing in your gut.
Bond funds typically maintain a duration target which makes the value of your fund sensitive to interest rate movement.
Yield to Maturity (YTM) of a bond is the (theoretical) internal rate of return earned by an investor who buys the bond today at the market price, assuming that the bond is held until maturity, and that all coupon and principal payments are made on schedule.
Many of you already own bonds indirectly (when you put your money into a Pension Fund, Mutual Fund, Insurance contract, ETFs, etc.). How much money you have restricts the ways you can access bonds. If you're like me and most other people, you have to get your bonds in some kind of fund format and pay umpteen-layers of middlemen, each taking a bite of your cheese.
Bond funds invest in bonds, but they don't do what bonds do. Bond funds are bets on the direction of interest rates and a particular manager's skill, or unskill. Bond fund managers are richly rewarded to add sufficient risk to cover their fees, expenses and whatever else they claim to provide. To make it easier for them, big bond institutions coral small clients into comingled investment products (mutual funds, closed-end funds and UITs) with high fees, while elite clients get separately managed accounts at more competitive prices.
Duration is a measure of the average timing of future cash flows. Bond funds are typically managed to a duration target near their stated benchmark. Those target duration may fluctuate a bit, but they never go to zero in a mutual fund.
Do you know what a duration of zero is? It's you getting your money back.
Currently, there are only two groups of investors who primarily trade in individual bonds, the big investment firms and ultra-rich individuals and family offices. They can purchase bonds in the following way:
Buy bonds directly
Invest in Hedge Funds, Mutual Funds, etc.
For most retail investors bonds are owned via:
Mutual Funds or ETFs
Bank Trust Departments (HNW)
You often hear that there has been a generational bull market in interest rates. Do you know who that benefitted the most? The enormous active bond shops who were basically just increasing your duration exposure through leverage and exposing you to excess risk that worked because interest rates were going down.
Bond fund companies sell you on their "credit expertise". If you're buying your own stocks, you intuitively understand credit because you're, "buying the residual stub." What that means is bondholders are made whole (paid in full) before stockholders are entitled to a dime.
Arthur's Rising-Rates Environment Pitch:
When a Bond Matures You Get Your Money Back, Period
When you buy a bond for the purpose of adding stability to a portfolio of high volatility assets, all you need to do is hold it to maturity.
It doesn't really matter what happens to the direction of interest rates; when a bond matures, you get your money back.
That doesn't happen in a bond fund where the yields look so impressive - just don't look at how the sausage is made because that's where you'll find the risk you are exposing yourself to.
And if you think rates are going up, you absolutely do not want to be long a whole bunch of constant duration in a high yield bond fund.
Some ways are just plain better
Many bonds have minimum purchase amounts and are not very liquid in small sizes, leaving few opportunities for individuals to buy them directly. With fewer ways to own a bond, retail investors end up paying the costs associated with purchasing and managing those bonds via third parties.
In your case, better means more return, more certainty and lower costs. Let's see how each way of owning bonds differs:
Mutual Funds: it's easy to buy; typically pretty expensive, charge fees around 1.5% to 2.5%.
ETFs: Range from expensive to really cheap depending on active versus passive. Generally less expensive than Mutual Fund equivalents.
Passive is cheap, but passive almost always underperforms because indexing rules drag on performance. Indirect costs includes the constant friction of trading bonds in their last year, which just reduces returns.
SMAs - Separately Managed Accounts - non-comingled fund that directly holds bond on your behalf generally has many levels of fees and not particularly customizable if less than $50 million.
Buying Directly: NO ANNUAL MANAGEMENT FEES. Hold to maturity and you know your holding period return. (remember, it's called Yield to Maturity). When a bond matures you get your money back.
There are no fees to own your own bonds.
Most investors don't think about the fees they are paying when investing in a fund of bonds. Depending on the cost structure, you may end up only getting 50% of what you earned as interest due to indirect costs from management fees and others. The total amount you receive may look like a big number, but what level of risk are you accepting?
Stop complaining about how low yields are, stop paying somebody else to do the work for you that you can do yourself - How much could you use another 1% in yield from your bond exposure that is simply going to some non-carbon-neutral private jet (you do know that's how Bond Fund Royalty travels, right?)
What are SMAs?
Separately Managed Accounts (SMAs) are basically just like mutual funds, except you pay somebody to allocate the positions individually to your ledger which gives you the benefits of direct ownership.
Why do you suppose that all the big bond shops offer separately managed accounts to their High Net Worth (HNW) and Institutional clients?
If it's better for HNW clients, wouldn't it be better for everybody?
Answer: Probably, I know it certainly would be for me.
So why don't they offer SMAs to everybody?
Answer: They can't actually do it because it requires completely new technology.
Listen, there is absolutely, positively, unequivocally no denying that direct bond ownership is a better way to invest in bonds, but the minimum holding size per position is typically about $10,000. This means you need around a $500,000 minimum to have the big guys even be able to operate your account. But let's be real, you're not actually getting an individually managed account at $500,000, you're getting a separately accounted, un-comingled, one-size-fits-all strategy and paying nearly as much in fees and expenses as you would for a mutual fund. Take it from a former insider, real separately managed accounts start at $50 million.
Buying your bonds directly is the best way
Because direct investment provides certainty in holding period returns while funds are bets on interest rates and manager skill, or unskill; where the bond manager is "The House".
Owning a bond directly offers you the choice and flexibility of finding something that fits your investment horizon, goals, values and social preferences without the extra management fees and other indirect costs.
Owning your bonds directly allows you to get cash via the interest and coupons and cut out the middleman; there are no management fees to detract from your hard earned coupons.
Owning your bonds directly means that when a bond matures, you get your money back.
Arthur.bond will make bonds accessible to everyone.
The Founders of Arthur come from the investment management industry. We witnessed the restricted access to direct bond investment firsthand and understand just how much money is being made on the backs of retail investors.
That is why we created Arthur. We are simplifying the process of purchasing a bond in order to offer you easy access to the bond market. We're building Arthur as a community so, together, we can learn how the $50 trillion bond market can be harnessed to fund every single one of our future cash flow needs without paying for the packaging.
Soon, Arthur will eliminate the need to wait for auctions, substantial per-security minimum investment amounts and the enormous spreads in the retail secondary market. Once we do that, there is no longer any need for a bond fund wrapper, or manager to build a completely customized, diversified portfolio of bonds.
Don't kid yourself, this will save you a ton of money over your lifetime!
That's all the Bond Kings & Queens have, their ability to keep you out of the bond market - it's the only way they can maintain their enormous management fees.
Sign up for early access here and be a fundamental part of the democratization of the institutionally-restricted bond market.
*If holding individual bonds directly is better for institutional investors and the elite (who actually demand it), don't you think it's absolutely, positively, unequivocally better for you too? Sign up for early access.