What is the best way to buy bonds? There is no perfect answer to this question. The ultimate answer, like most questions in the investment industry, depends on the individual needs and circumstances of the investor. Let’s walk through some different ways to buy bonds and the pros and cons of each.
Buying a bond fund
Bond funds give investors the ability to buy an instantly diversified portfolio of bonds. A bond fund will consist of many different bonds with different terms, types, durations and yields. They are easy to access as their minimums are low. They are also easy to sell since they are valued on a daily basis.
The biggest criticism of bond funds is that in many cases the management fees are too high. The average management expense ratio (MER) for Canadian bond funds in 2011 is about 1.7%. This has remained fairly constant from 2001 when the average MER for Canadian Bonds was also 1.7%. Remember that this is the average MER. Bond fund MERs range from a low of 0.10% to a high of 3.43%.
With bond funds, it has been proven that fees do make a difference but they are not the only determinant of value. If you buy a bond fund, shop wisely because they are not all the same. Look for bond funds with lower MERs.
The professional managers of these funds will tell you that a bond fund will give you a more sophisticated approach to buying bonds. They argue that they can employ management strategies that the average investors cannot do themselves like active bond trading, managing bond duration, and having access to different types of bonds. I heard Bond Fund managers argue they can also buy bonds at a better rate simply because of volume.
Buy your own bonds
Critics of bond funds argue that you can create your own diversified bond portfolio by buying individual bonds. Many do it yourself investors feel that buying bonds is not as sophisticated as these bond fund managers make it out to be. They believe that most bond funds are simply an over-diversified ladder of bonds bought and held to maturity, and that the amount of work to ladder a portfolio of bonds does not justify paying 2% in MERs.
The bottom line is that you can save yourself a lot of money if you have the time, energy, resources and knowledge to buy a ladder of bonds and manage it yourself. Some suggest that to build a diversified bond ladder, you need a minimum of about $25,000. There’s no hard and fast rule but given minimums and the amount needed to properly diversify a portfolio, $25,000 is a good starting point.
Certainly buying individual bonds is an option but many people may not have the knowledge, desire or ability to research individual bonds properly.
Buying Bond Exchange Traded Funds
The third way of buying bonds is through Exchange Traded Funds (ETF). Bond ETFs have become very popular. According an article by Personal Finance Columnist Rob Carrick, Bond ETFs account for 25% of the $42billion invested in ETFs in Canada.
A bond ETF is like a mutual fund in that it has a diversified portfolio of bonds but it trades more like a stock than a mutual fund. In most cases, the Bond ETF fees are very low compared to mutual funds because the performance mimics a bond index.
There are many different options but here are three excellent choices as core bond holdings:
- BMO Aggregate Bond Index ETF
- iShares DEX Universe Bond Index Fund
- Vanguard Canadian Aggregate Bond ETF
My five cents
In my portfolio, I have never bought bonds directly or set up a bond ladder. Instead, I have been a GIC rate shopper and have found that returns of GICs are similar to government bond rates but without the volatility. Obviously, when bond returns are pushed up because of falling interest rates, GICs to not experience that same upside. That being said, GICs never drop in value so a GIC ladder gives some peace of mind.
In my RRSP portfolio, I have primarily used bond funds in the past but now, I much prefer the lower fees from Bond ETFs. This is really important since my research on fees suggest that lower fees is more important when it comes to bonds and fixed income investing.
How do you prefer to buy bonds? Do you have a different approach altogether?