To run a successful financial advisory business, we need to differentiate ourselves from our competitors. This differentiation is both a business necessity as well as a highly desirable quality. We all seek to offer a genuinely superior investment journey for our clients. But let’s make sure that those differences are actually in a client’s best interest. Here, I focus on the area of fixed income. In an effort to “differentiate,” advisors are at times delivering their clients small portfolios of individual bonds instead of commingled vehicles (i.e., ETFs, ETNs, closed-ends, open-end mutual funds). Let us not equivocate—it is a rare circumstance when such a portfolio of individual bonds is in the best interest of a client with less than $10 million.
To frame the issue, let’s take a hypothetical client with a $450,000 fixed-income portfolio. An advisor has purchased for this client a portfolio of 10 municipal bonds, each of which is valued at approximately $45,000. This portfolio suffers from the following six risks for which there exists no compensating increase in expected return:
Bankruptcy risk. If one of the municipalities declares bankruptcy, this event affects 10% of the portfolio. In a properly diversified commingled fixed-income vehicle, this risk would have been eliminated in that it would have been diversified away. The bankruptcy of a single issue within such a well-diversified portfolio would not move the needle.
Default risk. If one of the municipalities threatens default on an interest payment, this action negatively impacts the pricing on 10% of the portfolio. Again, in a commingled vehicle, this risk is diversified away. Threatened default by a single issue cannot move the needle in an ETF. But in an individual bond account, if one of those bonds threatens default, how will the advisor explain this to the client?
Downgrade risk. The downgrade of individual municipal bonds is all too common. In this hypothetical example, the credit downgrade of a single issue meaningfully impacts the entire portfolio because of the 10% weighting. In contrast, the downgrade of a single issue in a commingled vehicle won’t budge the needle. Again, in an individual bond account, if one of the 10 bonds is downgraded, how will the advisor explain this to the client?
Idiosyncratic risk. If the advisor picks only 10 issues, the client also faces significant “idiosyncratic risk”: In other words, factors unique and specific to a given municipality can harm a portfolio’s returns. In an efficient market, such risks are never rewarded, for the simple reason that they are diversifiable.
Operational risk. Each of these individual municipal bond portfolios is unique. This breeds extreme operational and back-office complexity. For example, if the advisor’s office oversees 1,000 individual bond accounts and each one is different, how will they know when an interest or a maturity payment has arrived and is waiting for reinvestment? Will they check all 1,000 accounts every day? What if a corporate event (e.g., a merger) takes place that affects the underlying bonds? Will the advisor check all 1,000 accounts each day hunting for corporate events? Cash could accumulate before it is noticed and reinvested. Systems to manage these operational hurdles are expensive and costly to manage, and many advisors cannot afford the expensive systems that mitigate such operational risks.
Liquidity risk. This is a large and overriding risk, which potentially dwarfs the others—which is not to say that the previous five risks are inconsequential. They aren’t. Municipal bonds carry frighteningly large bid/ask spreads. They can be bought at one price (high) and sold at an entirely different price (low). In 2004, Vanguard portfolio manager Christopher M. Ryon, now at Thornburg, made a presentation to the U.S. Senate Committee on Banking, Housing, and Urban Affairs showing that the typical bond appearing in the hypothetical case described above (not a bad or an illiquid one, just the average) would suffer from a bid/ask spread of 213 basis points. In today’s interest rate environment, where the five-year U.S. Treasury bond is paying just 1.63%, it is unacceptable to have a client pay a 2.13% bid/ask spread in order to buy individual municipal bonds. A second study, published in the September 2004 edition of the Journal of Fixed Income, estimated that the typical bid/ask spread for municipal bond trades of the size presented in this example averaged an even higher 246 basis points. A third study dated March 31, 2012, by the Municipal Securities Rulemaking Board (MSRB) estimates that the municipal bond spread as a percentage of par is 2.10% for trades smaller than $25,000.
Often, clients are misled by their monthly client account statements. Such statements will report prices for the municipal bonds held in their accounts. But these prices may often deviate quite significantly from what the bonds could actually be sold for. If faced with a sale, how does the advisor explain to the client this deviation from what was reported in the client statement? If an advisor persists in building a small portfolio of individual municipal bonds for a client, perhaps the advisor should consider having a discussion with the client about what the price would be to purchase the portfolio and also what the price would be to sell it—explaining the size of the gap between these two numbers.
Many institutional investment management firms that have extensive working relationships with high-net-worth clients in the municipal space have long recognized the six challenges outlined above. Often, they have developed well-designed structures to mitigate these issues. The Bernstein organization provides one such example. For many years, it has maintained a liquidity vehicle (a private municipal commingled vehicle) that it uses as a segment of a high-net-worth client’s larger portfolio of individual muni bonds. This commingled vehicle then acts as a cost-effective shock absorber to absorb cash inflows or to supply cash outflows—thereby avoiding the painful and inappropriate realization of the municipal bid/ask spread (the 213, 246, or 210 basis points noted above) when individual bonds are bought or sold.
In truth, it is difficult for an advisor operating as a fiduciary to place a small client account into a portfolio of municipal bonds such as the one described above. Nevertheless, situations do exist where it may be quite appropriate. For example:
Accounting rules. Certain unique organizations may operate under accounting rules that allow them to hold individual bonds on their books at cost (unless they are sold). Insurance companies are a common example of this type of organization. In such circumstances, a strong and prudent motivation exists for the holding of individual bonds.
Hold until maturity. Many individuals will never sell a bond prior to its maturity. Instead, their periodic cash-flow needs are satisfied by their other assets or by the interest payments generated by their bond portfolio. For such individuals a portfolio of individual bonds, strictly held until maturity, could be the single best solution. Many elderly may fall into this category.
Optics. For a few investors, the psychological and behavioral benefits of holding just individual bonds outweigh the six risks outlined above. As long as the client understands and fully appreciates the six non-compensated risks, then it is appropriate to hold individual bonds that take into account the client’s emotional needs. However, client education should reduce the frequency of these situations.
Large accounts. Smaller fixed-income portfolios face the six risks outlined. However, the effects rapidly diminish with increasing account size. When the account grows to $10 million, the argument against the construction of individual bond portfolios may become less important or nonexistent.
But this is a topic on which to avoid complacency or fuzzy thinking. As fiduciaries, we have an obligation to steer our clients away from the six unrewarded risks outlined above. With the advent and continued rapid evolution of the commingled fixed-income arena (ETFs, ETNs, CEFs and mutual funds), the liquidity, bid/ask spreads and internal expense ratios of a vast range of fixed-income instruments have reached a point where almost any client need can be best served through the strict avoidance of individual bonds. Let us not equivocate on this point.
Rob Brown, PhD, CFA is the chief investment strategist at United Capital Financial Advisers LLC in Newport Beach, Calif.