Investing in bond funds vs. bonds directly

We monitor the trends of the bond market in Lithuania and see an increasing number of private debt funds, both from existing fund management companies and from new players. At the beginning of January, real estate fund manager Capitalica Asset Management launched a new bond fund, and also a new private debt fund manager, Sound Asset Management, is expected to start operating in the market soon.

There are not that many bond funds in Lithuania in general and new funds are created relatively infrequently, so we decided to compare investing into bonds directly vs. through a bond fund, and review the pros and cons for the investors. In case you wonder which investment method would be more favorable for you.

For the sake of simplicity, we will compare the private debt funds that negotiate deals directly with borrowing companies, and we will not touch upon the funds that earn money not only from structuring/holding bond positions, but also from actively trading listed bonds, when the returns are generated not only from the interest (coupon), but also from the differences in bond prices. An example of this type of strategy can be a Baltic corporate bonds fund managed by Milvas.

The advantages of investing through a bond fund compared to investing in bonds directly:

Diversification. Bond funds’ portfolios consist of various companies (issuers) bonds, which often represent different sectors. In this type of fund, geographical diversification is also likely. The level and type of diversification depend on the fund's investment policy, but for investors investing in a bond fund is likely to achieve greater diversification than investing in a single or even a dozen bond issues. Therefore, in theory, by investing in a bond fund, you will be more protected in the case of a default situation for one of the positions.

Professional investment. The bond fund manager is a professional investor, so he or she is likely to be better at assessing the terms, potential, and risks of bond issues, evaluating the company's business model, and choosing the best options in the market. In addition, you will not have to worry about when and which issues are offered, nor take care of their technical acquisition, securities storage, etc. So you will save time and energy (yay!).

Availability and negotiating power. The majority of positions in bond funds are not available to retail investors, as negotiations between the borrowing company and the fund manager usually take place directly. In addition, the fund managers can use the negotiating power of one large investor, unlike the retail investors, who usually do not have the opportunity to negotiate and therefore must accept the existing terms of distributed bond issues.

Possible tax advantages. If you invest in a Lithuanian bond fund as a legal entity (i.e. UAB or MB in Lithuania), the income received from that fund by the legal entity will not be taxed. You will only have to pay tax on legal entity’s dividends, if you decide to take out money for yourself as a shareholder.

Disadvantages of investing through a bond fund compared to investing in bonds directly:

High investment entry barrier. In most cases, only informed investors can invest in bond funds, which means that the initial investment amount will start from € 125 000. There are also several funds on the market where the minimum investment amount starts from € 20 000 – 30 000. This might change in the middle of this year, with the Bank of Lithuania amending the existing regulation, when the fund managers will have the opportunity to assess the knowledge and experience of potential investors and to approve investors with smaller investment amounts. In this case, the investment entry barrier would be reduced, but other criteria, such as investment knowledge, would remain. Meanwhile, in most cases, it is possible to invest directly in bond issues from a minimum of € 1 000 or even € 100.

Limited freedom of choice. When investing in a bond fund, all decisions about investments will be made by the fund manager. In most cases, it is likely that the fund manager will be a more experienced investor than you, and you will probably invest with the manager that you trust. Nevertheless, sometimes investors want to choose for themselves or disagree with the manager. In this case, direct investment in bond issues is more suitable for these types of investors.

(Un)fixed return. The future returns of funds are targeted, i.e. indicative, and are also affected by the funds’ costs. For example, a bond fund ‘promises’ an annual return of 10%, however, it is not a commitment to achieve such a return, so the final result may differ, depending on the costs and the investment results of the fund. By investing in a specific bond issue, you can expect a fixed return, of course, if the issuer does not face solvency problems. At the fund level, you will also pay management fees and sometimes a success fee, which will affect your final return, whereas when investing in direct issues, additional costs other than for the custody of securities, are unlikely.

Another important aspect is the period of time for which your money is ‘locked’. Typically, bond funds ‘lock’ investments for about 2-5 years (this is stated in the fund’s offering documents). However, usually the fund pays its investors an agreed interim return every quarter (or similar), e.g. 5% per annum, which is less than the interest paid in full at the end of the fund's life. Meanwhile, although the term of specific bond issues varies, you can choose whether to 'lock' your money for a few months, 1-2 years, or 10 years by choosing a specific issue. The specified interest is paid at an agreed interval (usually quarterly or semi-annually).

Last, it is important to evaluate how much a specific bond fund can offer in terms of value-add, compared to personal investment. As we discussed, there are several strategies that funds follow: (a) some bond funds simply buy parts of publicly available bond issues in the market (you can do this yourself); (b) other funds structure bond issues themselves (only their clients have access to these issues); (c) third type of funds, while also using the first and/or second strategy, additionally earn from bond trading in the secondary market (thus creating additional value).

What is the conclusion? Probably, like always, everything depends on your goals, possibilities and priorities. Even though the fact that often there is no one right answer in the field of investing can cause irritation and impatience, it is always good to know the main features, possibilities and drawbacks of different investment instruments, and then make the decisions that are right for you individually.