Appeal of higher yields has more advisers trading individual bonds instead of funds

While stock and bond funds have seen assets decline, direct ownership of individual bonds has increased over the past year.

Spiking bond yields resulting from the Federal Reserve’s efforts to tamp down inflation have reversed a decades-long trend of owning packaged bond funds over individual bonds.

The growing appeal of investing in individual bonds is partly driven by technology platforms making it easier to trade bonds, but also suggests more aggressive and tactical efforts by advisers to take advantage of the current interest rate cycle.

“With higher rates, advisers are selling mutual funds and buying individual bonds and building laddered portfolios for their clients,” said Dave Rudd, president of InspereX, a fixed income distribution and trading firm.

Analyzing Finra and Sifma data, Rudd found that at the end of the third quarter this year individual investors held $4.31 trillion worth of debt securities, up from $3.29 trillion a year earlier.

While direct ownership of bonds is on the rise, indirect ownership through funds declined to $5.05 trillion at the end of the third quarter from $5.86 trillion a year earlier.

In comparison, indirectly held stocks declined to $12.4 trillion from $16.3 trillion over the period, and directly held stocks declined to $24.3 trillion from $30.7 trillion.

Stocks and bonds have all generally declined in value over the past year, so the data includes market performance. But Rudd contends that the individual bond ownership story is significant and reflects a potential turning point in the way advisers build fixed income allocations.

“It’s a pretty significant shift out of mutual funds and into individual bonds,” he said. “Advisers are finding value in using individual bonds even though it’s easier to just put clients into packaged products.”

In November, InspereX surveyed nearly 300 advisers across various channels and found that advisers are increasingly turning to individual bonds to improve client relationships, hedge inflation and add alpha.

Among those advisers using individual bonds, 82% are building bond ladders for their clients.

A key driver to the growing appeal of individual bonds, according to Rudd, is technological advancements that increase access and transparency around bond trading.

Rudd considered it a positive sign that access and transparency have been replaced by challenges related to bond pricing as the biggest headache facing advisers trying to trade bonds.

When advisers were asked why they don’t use individual bonds, the biggest reasons were clients not asking for them, managed products being easier to use, and evaluation of individual bonds being too time consuming.

“The focus has shifted to pricing and valuation,” said Rudd. “This is good news because we strive for access and transparency.”

Beyond fixed income, advisers expressed a tempered optimism regarding the markets and economy in the year ahead.

Roughly half of the survey respondents said they expect the stock market to gain at least 10% in 2023, including 13% of advisers who expect stocks to gain 20% or more.

However, the general bullishness for equities was presented against the backdrop of an inverted yield curve that is likely to hang around for at least the first half of 2023.

Three-quarters of respondents believe the yield on the 2-year bond Treasury will continue to be higher than that of the 10-year Treasury for several months.

Inflation, meanwhile, is less of a concern with 74% of respondents saying they feel inflation has already peaked.

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