Buying bonds or bond funds - which way to go?

It's tempting for your average investor to want to play part-time bond fund manager, by buying individual bonds for their investment portfolio, as opposed to investing in a relatively more expensive bond fund.

After all, why pay initial sales, and yearly management fees, for a bond fund yielding 6.4%, when one can buy a General Motors 2011 bond paying 10% a year? General Motors is the world's largest auto manufacturer, a $15 billion company, and is too large to fail, right?

Think again. The answer to this ongoing debate depends on a number of factors - but the consequences of getting it wrong can be disastrous. Just ask the hundreds, if not thousands of Maltese and Gozitan investors who lost tens of millions of lira owning Argentinian government bonds.

The fact is that few investors are aware of the genuine risks inherent in buying individual high yield corporate and emerging market bonds, and lack the necessary sophistication in analysing these instruments.

Even experienced investors can't rely solely on the opinions of credit rating agencies like S&P, Moodys and Fitch; they have in the past been criticised for being reactive and slow in their downgrades, as was the case in the largest corporate collapse in US history - Enron Corp.

Few investors are aware that countries can, and in all probability will, continue to default on their debt, as did Argentina, Russia, Ukraine and Ecuador. In fact, some market watchers have suggested that the relatively lenient terms Argentina won in their restructuring efforts will incentivise more countries to default, rather than go through the often painful and socially unpopular IMF-mandated economic restructuring plan.

Even fewer investors are aware that corporations default at much higher rates, as was the case in the global 2002 economic recession, with over 12% of all high yield debt defaulting, higher than the 10% average in the 1990-91 economic downturn.

With the size of the global high yield debt market surpassing $1 trillion, the prospects of even greater defaults in the next economic slowdown have increased.

Does this mean investors should shy away from this class of higher yield and emerging market debt? Absolutely not; quite the contrary. Investors, regardless of risk tolerance, should consider investing a small part of their portfolio in this investment class, provided their exposure is in a diversified, well managed fund.

Funds or collective investment schemes pool investors' money and invest in particular classes of investments, as mandated by the fund prospectus. Research and modern portfolio theory has suggested that although owning one, two, or five high yield or emerging market bonds is dangerous, owning hundreds of different issues offers enough diversification to reduce event risk, and could lead to strong returns.

While the Morning Star Emerging Markets Bond Index gained 150% in the past 10 years, the average emerging market bond fund managed to gain 8.8% in 2001, the year Argentina defaulted, and yet so many Maltese and Gozitans ended up losing much of their wealth.

Why did these funds do so well? This is because fund managers may have had as little as 3% to 5% exposure to Argentina in their portfolio. In fact, because funds are actively managed, managers may have sold their Argentinian bonds prior to default.

Fund managers go through great lengths to diversify their holding. Not only will they minimise their position in an individual bond; they limit their holding in a particular industry or geographical region.

It's also worth noting portfolio managers have teams of analysts at their disposal not only dissecting balance sheets, but doing due diligence and visiting corporations and countries, perhaps as often as once a quarter.

Many of the larger funds have access to central banks, government officials and corporate officials, which your average investor is denied. Also, economies of scale ensure that fund managers can trade individual bond issues at the best spreads, with the lowest commission. Not to mention that managers dedicate much of their day focusing exclusively on micro and macro issues relating to their market, and are truly experts in their field.

In addition, their remuneration package is a function of how well their fund outperforms their respective index. Fund managers are also keenly aware that continued underperformance usually means being unceremoniously sacked, so they are truly incentivised to do well, and generate profit.

It should, at this point, be painfully obvious that investors cannot, over the long term, outperform seasoned bond fund managers. Individual investors don't have access to timely research, split second news, reduced commissions, tight spreads, the ability to diversify into hundreds of issues, the sophistication and the time necessary to analyse and manage this type of investment.

Does this imply, however, that investors should never dabble in individual bonds? As a general rule, they should not, but there are limited circumstances where it does make sense.

Government and super national bonds from large industrialised countries ranging from the US to Australia, tend to have AAA to AA credit ratings, and are rarely downgraded.

The implication is that these governments, in all probability, will never default on their debt, and are very safe. Theoretically their short-term debt, i.e. Treasury bills and two- to five-year notes, are even safer, as their short maturities make them less price-sensitive to inflationary pressures.

Therefore, if an investor wanted an ultra safe short-term investment, buying government treasury bills and notes should be encouraged. But why not buy longer-term maturities like 10-year notes and 20-year bonds?

Again, individual investors rarely can outperform even an AAA-rated government bond fund. The reason is that although bond fund managers must hold bonds even in bear markets, they use defensive techniques to protect their returns.

Many fund managers incorporate derivatives to hedge downside risk, and focus on owning shorter duration bonds, to minimise losses - a skill most investors lack. The same could be said of high to medium quality corporate bond funds.

Although the bonds of large multinational corporations with sound balance sheets tend to be quite safe, there is no guarantee negative developments won't transform an investment grade bond into junk bond status.

Whoever thought a blue chip company as venerable as General Motors would be weighed down with $5 billion in yearly medical and pension fund costs, and $110 billion of bond debt outstanding? In a worst-case scenario General Motors may even file for chapter 11 bankruptcy - the ultimate nightmare for bondholders, many of whom are sitting on substantial losses.

The temptation to bypass a bond fund and invest directly in individual bonds may at times be great, but unless the investor and financial adviser are seasoned and savvy, this urge should be suppressed.

In the past 10 years your average sterling bond fund was up over 100%. Wasn't a small initial sales charge, and half a per cent yearly management fee a small price to pay for 10% average yearly return, and peace of mind?

Joseph Portelli is a financial planning officer within Globe Financial Management Limited's Gozo office. For more information send an e-mail to info@globe.com.mt or contact him on tel: 2156-2228. Globe Financial Management Ltd is licensed to conduct investment services business by the Malta Financial Services Authority.