March 18, 2025
Dear Investors and Friends,
Over the past three months, we’ve explored the fundamentals of fixed income investing, answering two crucial questions: Why Bonds? and What Bonds to Buy? This month, we move into the third phase of our series—How to Buy Bonds. Given its importance and complexity, we’ll explore this topic deeply over several letters, beginning with today's topic: Bond Funds vs. Individual Bonds.
Bond Funds: Popularity and Misconceptions
Today, approximately 90% of individual investors’ fixed-income assets reside in bond mutual funds or ETFs (Investment Company Institute). Why are these funds so popular?
- Ease and Accessibility: Buying bond funds is straightforward and convenient through brokerage or retirement accounts.
- Instant Diversification: Funds typically hold hundreds or thousands of securities, spreading credit risk across numerous issuers.
- Perceived Simplicity: Investors believe funds reduce complexity, eliminating the need to directly select and manage bonds.
Yet many investors overlook a critical distinction: When you buy a bond fund, you're not directly owning bonds—you're owning shares in a fund, essentially an equity investment whose underlying holdings are bonds.
This subtle distinction introduces risks that investors often underestimate, including:
- Undefined Maturities: Unlike individual bonds, bond funds have no set maturity, exposing investors indefinitely to interest rate risk and principal volatility.
- NAV Volatility: Bond fund values fluctuate daily, leading to potential surprises during rising interest-rate environments. For instance, during recent interest rate hikes, many bond funds experienced NAV losses of 15-25% or more, even those marketed as "safe" or "core bond" options.
- Tax Inefficiencies: In volatile markets, bond funds often distribute taxable capital gains—even in years when investors incur losses. According to Morningstar, nearly 70% of bond funds made taxable distributions in 2022 despite negative returns.
- Hidden Costs: Management fees and trading expenses quietly erode returns, compounding negatively over time. Investors commonly overlook these hidden drags on performance.
- Credit Risk: Bond fund managers—not investors—decide which securities the fund holds, potentially including bonds of lower credit quality than an investor might otherwise choose, increasing default risk unexpectedly.
- Liquidity Risk: Bond fund managers—not individual investors—control the liquidity profile of the underlying portfolio. During periods of market stress, less liquid securities become challenging to sell, forcing managers to liquidate holdings at disadvantageous prices, further harming investor returns.
- Redemption Risk (Mutual Fund Gates – SEC Rule 22e-4): Mutual funds, including bond funds, may temporarily suspend investor redemptions ("gates") during periods of severe market stress. Though rarely enacted, these gates restrict investors’ access to capital at precisely the moment liquidity is most needed.
- Discount Risk (Closed-End Funds): Closed-end bond funds trade on market exchanges, often at significant discounts to their net asset value (NAV). This means investors may realize prices substantially below the actual underlying value of the fund’s bond portfolio, introducing another layer of volatility and unpredictability.
Sophisticated Investors Prefer Individual Bonds
Most affluent individuals and institutional investors—such as foundations, endowments, pensions, and insurers—prefer owning individual bonds directly or through Separately Managed Accounts (SMAs). For instance, Cerulli Associates reports that 80% of ultra-high-net-worth investors ($20M+) choose direct bond ownership via SMAs.
Why?
- Customization and Liability Matching: Individual bonds enable precise matching of maturities and cash flows to each investor’s specific needs, an impossibility with bond funds.
- Transparency and Control: Investors see exactly which bonds they own, why they're held, and how each supports their financial objectives.
- Defined Maturities and Reduced Risk: Holding individual bonds to maturity provides certainty around principal repayment, significantly reducing interest rate volatility risks.
- Superior Tax Efficiency: Individual bonds facilitate tax-loss harvesting, maximizing after-tax returns in ways bond funds cannot.
RCM’s Approach to Bond Investing
At Roosevelt Capital Management, we invest almost exclusively in individual bonds through SMAs. This strategic choice helps our clients avoid common pitfalls like unintended tax bills and NAV volatility, aligning their fixed-income portfolios precisely with personal financial objectives. Our disciplined, market-driven approach ensures we always select the most attractively priced bonds, optimizing yield without increasing risk.
In short, owning bonds directly through SMAs allows us to customize portfolios, improve outcomes, and deliver clarity and efficiency unavailable through typical bond funds.
Next month, we’ll explore how individual investors can effectively buy bonds in their own brokerage accounts, diving deeper into market execution and liquidity.
Thank you for your continued trust.
Warm regards,
David and Mike
Disclaimer
Roosevelt Capital Management LLC is a registered investment adviser. The information presented is for educational purposes only and is not intended to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.
Past performance is not indicative of future performance. Principal value and investment return will fluctuate. No guarantees or assurances that the target returns will be achieved, or objectives will be met are implied. Future returns may differ significantly from past returns due to many different factors. Investments involve risk and the possibility of loss of principal.
While all the values used in this report were obtained from sources believed to be reliable, all calculations that underly numbers shown in this report believed to be accurate, and all assumptions made in this report believed to be reasonable, Roosevelt Capital Management LLC neither represents nor warrants the values, calculations or assumptions and encourages each prospective investor to conduct their own review of the audits, values, calculations and assumptions.