By Kripa Kapadia and Sijing Tao
The rapid rise in interest rates has created opportunities for investors to invest in bonds with yields not seen since before the global financial crisis.
The yields currently across bond markets could make this a good time to increase their weighting in a portfolio, but knowing how to invest is just as important as knowing when to invest.
At first glance, buying individual bonds may seem advantageous: acquire them at a discount and watch them appreciate to par value over their holding period. However, many retail investors may be unaware of the hidden risks and opportunity costs that can hamper their ability to fully maximize their returns.
Buying the ‘leftovers’
Unlike the transparency of equities, which trade on centralized exchanges, bond trading is decentralized and requires access to specialized bond dealer desks to facilitate transactions. Without a centralized exchange structure, smaller investors are at a disadvantage because they lack a solid reference point for the prices they receive from bond dealers.
The ability to access the best prices comes from relationships professional investors build with dealers over time through the frequency, volume and size of trades.
Some of the most attractive opportunities in the bond market arise when a borrower comes to market with a newly issued bond. Professional managers who trade at a much larger scale get first pick at these new issues.
This means retail investors often get some of the less desired inventory after large institutions and fund companies have already selected and bought the securities they deem most attractive. Many DIY bond investors deprive themselves of the value of having an experienced fund manager to capture these opportunities for them.
Higher transaction costs
There is a large misconception that buying individual bonds helps investors and investment advisers “maximize yield” by sidestepping the fees associated with managed funds. However, a closer look at the data paints a different story.
RP Investment Advisors LP (RPIA) recently conducted a detailed study analyzing 20 months’ worth of historical data, comparing more than 10,000 trades executed by our portfolio managers to those executed by individual investors. The goal was to identify the difference between the average retail investor’s cost of execution compared to our own.
On average, we pay approximately 50 cents less than a retail investor on a newly issued $100 par bond. This disparity was mirrored in the secondary market, where, on average, RPIA could buy at prices 25 cents lower than a retail investor and sell at prices a similar amount higher. These price differentials can significantly impact returns, and this effect only becomes more pronounced as portfolio turnover increases.
Purchasing a fund may come with explicit fees, such as management fees and the costs of operating the fund itself. But once you factor in a manager’s implicit savings, which get passed onto investors, the cost of DIY investing may be more expensive than many investors might believe.
Lack of diversification
The vast majority of investors have a tendency for home bias. Canadian retail investors often lean toward Canadian government or corporate bonds to limit exposure to foreign currency risk and because many domestic bond desks may only offer a limited selection of global securities.
However, because Canada is a small market relative to the United States or Europe, this bias does not bode well for diversification. For example, a DIY portfolio that is heavily overweight the Canadian bank, telecom and energy sectors is particularly vulnerable should something idiosyncratic happen to the Canadian economy or to one of its primary industries.
In contrast, global fund managers have a much broader opportunity set and possess the expertise to select the right issuer and the right type of security. A large corporation usually has a single ticker that equity investors can follow and buy, but may have hundreds of bonds, each with different characteristics and claims to the issuer’s collateral.
Not all securities of the same issuer are made equal, and analyzing the differences and nuances between individual securities is paramount to avoid unnecessary complications. Fund managers have a significant advantage in security selection, since they have experienced credit research teams dedicated to analyzing sectors and security types to identify the best opportunities.
The ability to use hedging instruments also allows institutional-quality managers to reduce risk in the portfolio. This allows them to confidently access attractive opportunities from a diversified range of global issuers, resulting in a diversified and robust bond portfolio.
Although individual bonds can offer some protection, they limit the flexibility to adapt to the evolving market environment should better opportunities arise. The experience, breadth of knowledge, relationships and ability to actively trade with conviction and speed provides fund managers more flexibility in building resilient portfolios.
Earlier this year, many retail investors jumped into bonds when yields appeared tempting and rates were peaking. Today, those yields are higher, and value dispersions in the market are more pronounced, making the opportunity cost of DIY bond investing that much more glaring. Investors in actively traded funds enjoy the benefit of ongoing liquidity and flexibility to adapt to changing market conditions to capture these fast-moving opportunities.
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After enduring low yields for over a decade, investors are understandably excited to jump into the bond market. But to take full advantage of the opportunities in the current environment, understanding these significant risks is essential, which is where an experienced manager and choosing the right investment solution can generate additional value.
Kripa Kapadia is principal, Client Portfolio Management, and Sijing Tao is manager, Risk & Analytics, at RPIA. The above is for informational purposes only and does not provide financial, legal, accounting, tax, investment or other advice and should not be acted or relied upon in that regard without seeking appropriate professional advice. Additional important information can be found here.