Investing direct or through exchange traded funds (ETFs), or managed funds has advantages and disadvantages; just like investing in shares, the decision depends upon the individual. Here we present seven key considerations for investors when deciding how to invest in bonds.
This article was originally published on 20 March 2019 and was republished on 14 October 2019.
1. Four key direct ownership bond benefits
Four of the main advantages of investing in bonds direct are:
- Funds are returned to you at maturity
- Interest is known at the time you buy the bonds as is the date when interest is paid
- Investment decisions are based on expected future returns
- The opportunity to outperform by investing in and trading a smaller number of good relative value bonds
Unfortunately, these features are lost when you invest in a managed fund. When bonds mature in a managed fund or ETF, funds are usually reinvested. Income is absorbed into the fund and the fund manager pays a distribution which is typically quarterly.
Bond funds advertise historical returns. Direct investment projects future returns giving you a better sense of expected income and overall yield to maturity.
Source: FIIG Securities
Direct bond investment means you decide which companies’ bonds to invest in. While a bond broker might make suggestions about bonds to include in a portfolio, you retain full control and make the final decision. Direct bond investors know all of the companies in their portfolio and there is complete transparency in this regard.
If you invest direct, you can build a portfolio that suits your investment goals, whether these are based around low risk, high return or the delivery of a monthly cashflow. You also then make the decisions on when to buy, sell or hold, depending on your needs. Bonds, like managed funds, can be sold down in small parcels providing liquidity if needed.
On the other hand, if you invest in a managed fund then someone else makes the decisions about what to invest in, when to buy and sell and when to make distributions to investors.
You’ll need to decide if you want a passive fund (where there is no or little oversight) and the fund aims to replicate a benchmark or an active manager that oversees the portfolio. The distinction is often reflected in the fees, where higher fees are charged for active management. Returns for active funds can significantly outperform passive funds, but this is not always the case.
In a low interest rate environment, it’s much harder for actively managed funds to outperform after higher fees are deducted. Some investors prefer not to invest in certain sectors for ethical or environmental reasons or just because they don’t think the sector is worth investing in. Direct investing allows for that flexibility.
What about ETFs?
Other investors may turn to ETFs, an index based portfolio of underlying assets such as stocks, bonds, oil futures, gold bars or foreign currency that divides ownership of those underlying assets into shares. ETFs are usually structured as a managed investment scheme, where investors hold units in a trust. They can be great tools for retail investors to access markets where only institutional players existed just over a decade ago. See below for advantages and disadvantages of ETFs.
Source: FIIG Securities
3. Time and confidence
Those wanting to invest directly need to take the time to learn about the asset class. If you don’t have the time or perhaps don’t yet have the confidence, managed funds or FIIG’s MIPS product may suit you better.
4. Invest in corporate bonds with at least $250,000
You need a minimum of $250,000 to invest in Direct Bonds through FIIG. The minimum amount per bond is typically $10,000 which means you can buy up to 25 individual bonds.
Being able to trade bonds through a dealer/broker gives you distinct advantages - access to expert opinions on which bonds represent good relative value, access to new originated bonds not available elsewhere, research, and the opportunity to build relationships. You are not just a number and one of many.
For those with less than $250,000 to invest, a corporate bond fund is a good place to start.
It’s really important to understand what you’ve invested in. Don’t make the assumption that all funds are diversified. A fund like the AMP Corporate Bond Fund is well diversified with the top 10 holdings representing just 12% of the fund. But there are others such as the Russell Investments Australian Select Corporate Bond ETF with 100% of its holdings invested in the bonds of the ‘big four banks’ There is very little point using such a fund if your objective is diversification.
5. Transparency and fees
Most managed funds do not disclose more than their top ten investments. This means you don’t know what they have invested in. Fund managers typically don’t want competitors to know what’s in their portfolios but this makes it very difficult for investors to analyse the risk of the fund. Direct ownership means you know precisely what you own and can determine if the risk is appropriate for your circumstances.
One of the arguments against investing in bonds directly is the lack of transparency regarding brokerage fees. But anyone that transacts in bonds pays a brokerage fee, so whether you are investing directly or through a managed fund, you are paying brokerage. The advantage of the managed fund is that they buy bonds in larger quantities and so would achieve some scale.
Open an account with FIIG in less than 5 minutes
With a management fee of 0.8%, over an average 5 year investment you will pay 4% in fees. Typically a 5 year bond bought through FIIG will cost you approximately 1% upfront, although if you hold this to maturity that is not a ‘real’ cost – it represents a theoretical cost that you pay to access the market. You will receive the yield you expected at the price you pay, with no erosion of returns from ongoing fees.
At FIIG we produce a daily independent third party price list, found here.
As licensed custodial service providers, FIIG charges a custody service fee when you use our custodial service.
The custody service fee is calculated daily on the value of your account holdings and charged monthly. See estimated fees below:
For example, if a client had $2 million to invest:
Custody Service charge
For the first $500,000
@ 0.20% pa
For the next, $1,500,000
@ 0.14% pa
For more information, see our article on How to buy bonds or visit www.fiig.com.au/private/services/custodial-service
6. Those needing guaranteed short term liquidity
Bond funds don’t actually guarantee liquidity, but it takes a pretty extreme liquidity crisis (such as late 2008) to cause a large corporate bond fund to block redemptions. In normal times, redemptions occur within a few days. Individual bonds are generally widely traded and cash settlement could occur as early as 2 days after a trade is executed.
7. Diversification across your portfolio
If you own a lot of bank stocks or residential property, one thing to watch with a corporate bond fund is the level of bank exposure. Most of the large corporate bond funds have a very high (20%+) exposure to global banks, which means if you already hold bank shares in your SMSF, you are creating a very high allocation to banks across your whole portfolio. Direct bond ownership means you can tailor your bond portfolio to fit in with the rest of your portfolio.