Exchange Traded Funds (ETFs) are fantastic investment products that provide diversification at a relative low cost to investors. These funds can hold stocks, bonds, real estate, gold, or about any kind of investment you can think of. I use them for my clients and myself. However, when it comes to fixed income products there are some important reasons to consider using high grade individual bonds and CDs for your portfolio.
Predictability:
When you buy an individual bond, you know much you’re paying for it, how much it’s paying you, and how much you will receive when the bond is due. A steady stream of income can be created from several different individual bonds. This predictability can be particularly valuable for retirees relying on bond income to cover living expenses.
It is also helpful when you know a large expenditure is coming. Whether that is buying a house, paying for college, or any large ticket item, individual bonds can take the guess work out of returns. For example, you can buy a US Government Treasury or CD that comes due right before the date that you need the funds
Less Volatility:
Most bond funds have a target duration or time frame that they want to hold bonds. For example, the fund may target bonds that come due in about 10 years. To achieve is, they will usually own a collection of bonds that have 8 to 12 years until they are due. As time goes by and a bond has less than 8 years left, it will be sold and replaced by a bond that has 10-12 years left. They then go out and buy the best bonds for their fund. They are at the mercy of where current interest rates are at the time. This can lead to more inconsistent returns. Most bonds funds that aren’t very short-term funds don’t hold any bonds to maturity. This isn’t a criticism. It’s just how those funds work.
The strategy of using individual fixed income products works best using Certificates of Deposit or very high grade bonds, such as United States Government Treasuries and highly rated Municipal and Corporate Bonds. This greatly reduces risk of default. When it comes to lower grade and higher yield bonds, diversifying is very important. That’s why I do use ETFs for higher yield bonds. That’s when it’s better to pay them a small fee to own hundreds, or thousands, of different bonds from different issuers.
Avoiding Fund Fees and Expenses:
Bond funds typically charge management fees and expenses, which can erode investors’ returns over time. Most of the bond ETFs that I use charge very low fees, but they can add up over the long term, especially in periods of lower interest rates or market volatility. By investing in individual bonds, investors can bypass these fees and improve their overall returns.
Conclusion:
Building a fixed income portfolio is like putting together a puzzle. How much income is needed? How will this income be taxed? How much risk should I take? Diversification provided by ETFs is integral, but allocating at least some of your portfolio to individual bonds will take out some of the guesswork when you’re trying to solve your income needs.
