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For financial advisors and clients alike, bond ETFs represent an efficient, cost-effective, convenient solution. Their popularity so far this year, with net creations exceeding those of equity categories, is due in part to the continuing shift in the retail brokerage market away from direct holdings in bonds.

“If you look at a lot of portfolio managers or investment counsellors, ETFs make up a significant part of the fixed-income suite for them. It’s a growing area,” says Peter Hodgson, senior vice president and portfolio manager with Toronto-based BMO Nesbitt Burns Inc.

Should advisors whose clients are holding bonds make the switch? Among the key considerations are the size of the account, the client’s time horizon, transaction costs, management fees and taxes. Hodgson says building a portfolio of individual bonds might make sense only for clients with portfolios of $10 million or more.

For accounts smaller than that, he says, it’s difficult to buy, monitor and manage individual bonds for clients. By choosing to make bond selections, he says, “you’re acknowledging that you think you can add some value and that you have the most precious resource of time to actually do the selection.”

If the client has a specific holding period in mind, a direct holding to maturity of a high-quality bond such as a Government of Canada issue can be a preferable alternative because of the certainty of outcome. Unlike bond ETFs, whose values will fluctuate, the price of an individual bond at maturity will be its par value.

Portfolio manager John De Goey of Winnipeg-based Wellington-Altus Private Wealth Inc. generally doesn’t recommend individual bonds in portfolio construction, but he understands why someone might. “If you’ve got a definitive time horizon and you don’t want to be whipsawed by rising rates, [and] if you have a bond that matures in concert with your time horizon, that’s a good way to mitigate that risk,” De Goey says.

Hodgson cautions that retail clients do not always hold individual bonds to maturity, even if that’s what they originally planned to do. “Life changes. People change,” he says. Advisors should determine whether there is sufficient liquidity in a bond that a client might need to sell before maturity, Hodgson says, and they should also warn clients that a bond’s price will fluctuate before its maturity date.

GICs should also be part of the conversation with clients, Hodgson adds. Five-year GIC rates, for instance, exceed the yields on five-year Canada bonds and on high-quality bond ETFs with similar average maturities. GICs are also simpler for clients to understand because, unlike bonds or bond funds, they don’t fluctuate in price.

Hodgson notes that because market interest rates are low, investors must usually purchase individual bonds at a premium. Therefore, if clients hold to maturity, they’ll receive a lower price. “Make sure they understand that you’re buying something at a premium that will mature at par because rates are low.”

By buying bonds directly, investors will avoid paying fund management fees and expenses. But these savings may be inconsequential. Bond buyers must contend with bid-ask spreads that are wider than what institutional investors must bear. By comparison, the bid-ask spreads on some bond ETFs can be as narrow as a penny — especially on the larger funds, Hodgson says.

Furthermore, some brokerages charge commissions to buy and sell bonds. A commission of $15 or $20, says De Goey, would mean $150 or $200 in transaction charges to build a portfolio of 10 bonds. “That might be as much as or perhaps greater than the MER [management expense ratio] of the ETF, depending on your time horizon and whether or not you hold to maturity.”

De Goey concludes that fees are unlikely to be a material consideration in deciding between bonds and bond ETFs. He estimates that the MER of a typical bond ETF in a mainstream category will be about 20 to 25 basis points, and as low as 10 basis points. He says that with a large enough portfolio, and with lower diversification requirements, a high net-worth investor can probably save 10 or 15 basis points by buying bonds directly. But for most investors who don’t trade often, “the convenience, simplicity, safety and diversification of buying a bond ETF is worth the 10 or 15 basis points.”

Nor should tax consequences be a deterrent in switching from bonds to bond ETFs in non-registered accounts. In fact, the opposite may be true. Because of declining interest rates, holders of individual bonds may have significant unrealized capital gains, which are tax-advantaged. “The sad part is if you hold that to maturity, you turn that capital gain back into interest income,” says Hodgson. In non-registered accounts, clients may be better off selling the bond to capture that capital gain.

Tax consequences can also be mitigated by allocating as many fixed-income assets as possible to registered accounts. To the extent that the client’s fixed-income allocation must be held in a non-registered account, bond ETFs are simpler to deal with at tax time. There’s only one T5 tax slip issued for a bond ETF, versus many more if the client holds a portfolio of individual bonds. “It’s just easier to manage,” Hodgson says.

When it comes to diversification, it’s no contest. Investment funds hold a decisive advantage over individual bonds — especially for investors who wish to diversify by duration, credit quality or geographically, or to hedge foreign currency exposure. “Those are all sorts of things you can do neatly and tidily within ETFs,” De Goey says.

With individual bonds, investors must also contend with scarcity of inventory in the retail market for what they might want to buy. “What happens if you want to build a ladder, and you can buy a one, a two and a five, but you can’t buy any three or four years?” De Goey says.

No matter the credit quality, a bond default will have far less impact if it’s held in an ETF with other holdings. For example, two of the ETFs that Hodgson uses — Vanguard Canadian Short-Term Bond Index ETF and BMO Short Corporate Bond Index ETF — each has well over 300 holdings, and MERs of just 0.11%. “You really have diversified security-specific risk away,” he says.

Hodgson recommends against trying to build a corporate bond portfolio for a retail client. “The average advisor doesn’t have enough time to research the bond indentures and to build a proper diversified corporate bond portfolio. ETFs win hands down.” Even with ETFs or mutual funds, he says, advisors need to be aware of credit risks. With high-yield or emerging markets ETFs, “just recognize that when things get tough, that bid-ask spread can really expand on you.”

In less efficient fixed-income segments, investment funds make more sense. There’s also a stronger case to be made for active managers, provided that they’ve demonstrated an ability to add value versus their market benchmark, Hodgson says. “There’s absolutely a place for active fixed-income but there are places where I don’t think active makes a lot of sense,” he adds. “It’s just tough [to outperform] when you can buy the index for so little money.”