Bond exchange traded funds (ETFs) and passive bond market indexes can provide investors with easy exposure to a broad range of issuers and bonds. But it’s important for investors to understand exactly what they’re getting — and not getting — in comparison to actively managed bond funds.
“It’s certainly much easier to access ETFs and bond market indexes than to gain exposure to the individual corporate bonds of which they’re comprised,” says Timothy Hicks, chief investment officer at Lysander Funds Limited, a Canadian investment fund manager offering funds that specialize in corporate bonds. “But there are also drawbacks to seeking corporate bond exposure in this way.”
Typical passively managed index funds and ETFs offer lower expenses than their actively managed fund counterparts. They achieve that through a formula that attempts to replicate the composition, risk and performance of the broader bond market.
“Normally, the weighting of individual securities in passive stock indexes is determined by their market value,” Hicks says. “But if you try to apply that same thinking and strategy to a bond index it doesn’t make as much sense, because a bond index gives more weight to a company simply because it’s among the most highly indebted. Your algorithm will be building a fund according to how much a company has borrowed, irrespective of returns, of the quality of that debt and of the likelihood that you’ll be repaid.”
While the weighting of bond ETFs in the direction of companies with the greatest indebtedness could be addressed by a more active management strategy, any additional management would begin to layer fees on top of investment products typically advertising their low-fee credentials.
Bond ETFs also boast a high level of liquidity — they can be readily bought and sold through a discount brokerage account at a price that is updated constantly throughout the day. But there’s more to liquidity than meets the eye.
“While shares of the bond ETFs are liquid, the underlying bonds that comprise them are not,” Hicks says. “If a lot of investors in that ETF want to sell at the same time, the dealer managing that ETF would have to sell out a lot of bonds at a lower price.”
Bond ETFs and indexes also offer exposure to the broadest bond market possible. Diversified, yes. But to what end?
“You have to ask yourself whether you really want to own the entire bond market,” says Hicks. “Or do you want exposure to fewer bonds that represent higher quality debt?”
Individual investors can attempt to flip the script on an “entire market” bond investing strategy by directly purchasing individual corporate bonds through an investment broker. Although these bonds have less liquidity than an ETF — there’s limited ability to sell them on short notice — investors who favour them often like the predictability of buying and holding a bond until maturity.
However, these investors need to do their own research regarding the cash flow and collateral of the companies behind the bonds. The selection of bonds available to them is also much narrower than those available to investment bond specialists. And investors buying individual bonds on the retail market will pay more for the same bond than a bond investment specialist who buys and sells in quantity.
“Our value proposition aims to provide the best of all these worlds,” says Hicks. “The portfolio managers of our bond funds evaluate individual companies, and make a judgement about their ability to settle the bond when it matures. In doing that, our funds aim for better overall returns than the strategy of someone who is holding the entire market and to do so more efficiently than someone looking to invest in individual bonds themselves.
For more information on Lysander Funds, visit: https://www.lysanderfunds.com
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This story was created by Canadian Family Offices’ commercial content division, on behalf of Lysander Funds Limited, who is a member and content provider of this publication.