Buying Individual Bonds Is Not a Free Lunch
On occasion, I come across an person who invests in individual bonds. And without fail, they always claim that they don’t pay any commission when they purchase these. Often this is followed with a discussion of that’s why they feel bond mutual funds are a rip off.
Now if you buy individual Treasuries, there is a way to buy them directly without the middle man. But if you are buying from a broker there is a cost, you just don’t see it. Bond commissions are actually within the spread which is the difference between the price the broker pays and the price the firm sells it to clients. Spreads are influenced by the characteristics of the bond. For the individual investor, the problem lies within the trade size. The lower the dollar amount of the trade, the greater the spread you are going to pay. How much of an impact does the size factor present? If a recent study suggests, quite a bit:
Dollar Purchase Trade Cost
$25K or Less 2.23%
$25K to $100K 1.12%
$100K to $1M 0.36%
Over $1M 0.10%
That’s where an efficiency run mutual fund has the advantage as they can buy in bulk and minimize their spreads. Individual bond buyers can’t see the spread but they are made well aware of the expense ratio of a mutual fund. Being thrifty is important, but I think individual bond buyers in a lot of cases aren’t aware (or aren’t made aware) of this.
This isn’t the only reason why I prefer funds over individual bonds. Mutual funds provide more diversification. If you own individual bonds, it only takes one bond default to blow up your portfolio while funds have hundreds of holdings to diversify the credit and other risks. Mutual funds are also more effective if you have liquidity need as you can always sell off exactly what you need from a bond fund where you need to sell individual holdings to create the liquidity (and the spread happening again on the back side this time). The most important thing to get out of this is that you can still continue to believe that individual bonds are better, but they aren’t a free lunch.