If you have read our investment philosophy, you know that bonds (also known as fixed income) play a critical role in our portfolios. They serve to minimize loses during inevitable market declines, provide predictable income for reinvestment or cash flow, and are a stable source of funds to strategically purchase equities when prices are clearly cheap.
There are two ways we add fixed income to a portfolio: direct purchases of individual bonds, or the purchase of bond funds (a diversified pool of individual bonds packaged as a mutual fund or ETF). We have a solid preference for owning individual bonds with laddered maturities (a bond ladder), but also use some funds. Here’s why…
| Feature | Bond Ladder | Bond Fund |
| Minimum Investment | $250,000 minimum investment typically required | Minimum investment is usually low to none |
| Diversification | Low: 10-30 individual bond positions depending on portfolio size | High: Hundreds of individual bond positions held inside the fund |
| Costs | 0.15% to 0.30% for trading and ongoing credit analysis | 0.10% to over 1.0% fund expenses based on management style and types of bonds |
| Credit Risk (Default Risk) | Monitoring credit risk of each bond is critical since diversification is low – a single default can have a large impact on the portfolio, so bond ladders are usually limited to high quality bonds | Unsystematic credit risk is minimized through high levels of diversification |
| Interest Rate Risk | Since individual bonds can be held to maturity, interest rate risk is eliminated over the full holding period, but interim price changes will still be observed in the portfolio | A bond fund has no set maturity, and managers are often forced to sell individual bonds before maturity, so interest rate risk persists consistent with the duration of the underlying holdings |
| Income Stability | The process of rolling matured bonds to the end of the ladder each year results in a highly stable and predictable income stream | Income will vary based on the changing composition of the underlying holdings over time |
| Best Use | Core fixed income allocations such as municipal, corporate and government bonds whenever the minimum investment can be met | Strategic allocations to international, high yield and emerging market bonds, and core allocations when the bond ladder minimums can not be met |
