New issue bonds: A good alternative to bond ETFs?

Bond ETFs are gaining a substantial following among portfolio managers and investors.

Bond ETFs are gaining a substantial following among portfolio managers and investors. ETFs based on fixed income instruments are now about 20% of the total ETF market and bond ETF issuance has increased significantly in the last year.

Bonds ETFs offer instant diversification and tradability. But for many long term investors, Bond ETFs are still an unproven newcomer on the bond block. Bond mutual funds and individual bonds continue to make up by far the greatest percentage of current fixed income allocations.

Owning individual bonds in a portfolio may seem like ‘old news’ for some persuaded by the appeal of ETFs. However, many financial professionals do not consider bond ETFs or bond funds to be true fixed income instruments.

Individual bonds are designed to return principal at maturity or call date. This is not the case with bond funds or ETFs, which have no stated maturity. Bond funds and bond ETFs typically have a ‘rolling’ average maturity date or duration, with no certain maturity value. In practice, they are not by definition fixed-income securities.
Unlike bond ETFs or bond funds, individual bonds are typically purchased for a stated stream of cash flows.
With individual bonds, the adviser and investor control which bonds are held in a portfolio. With bond funds and ETFs, an ever-changing assortment of securities is under the control of the fund or index manager.
Additionally, interest rate risk tends to decline as a bond nears maturity. This may make individual bonds less vulnerable to changes in interest rates than bond funds and ETFs.

When considering individual bonds for fixed income allocations, new issues are often recommended. What are the potential advantages of new issue vs. secondary market bonds?

In many bond sectors, the new issue market offers investors an entry point which can simplify portfolio decisions with tax efficiency and clarity. While municipal bonds may be more difficult to purchase as new issues, several corporate and US Agency issuers offer bonds consistently in the new issue market.

Pricing clarity: New issue corporate bonds are typically offered at a par amount of $1,000 per bond. Secondary market bonds normally trade at discounts or premiums to par, with accrued interest. With no discount or premium pricing on new issue bonds, the coupon on the bond will equal the yield to maturity.

Tax considerations: At maturity a new issue bond will not incur capital gains or losses. Secondary market bonds almost always have more complicated tax consequences.

Underwriting fees: When buying a new issue bond, all underwriting fees are disclosed in the offering documents. Issuance fees typically range from 50-150 basis points on non-callable bonds, depending on the maturity and structure.

Consistency: For issuers offering a regular program, new postings are set each Monday. In most cases these offerings are available until the following Monday. This allows advisers and investors time to make an informed decision. The price (par) and coupon remain constant throughout the week, with all investors receiving the same yield to maturity when the issue closes.

Liquidity: While designed for buy-and-hold investors, liquidity is provided by numerous market markers. In the event of a market dislocation or credit concerns with respect to a specific issuer, bid-ask spreads can be wide. However, secondary issues normally trade in an orderly market and are reported on TRACE (see SIFMA’s site investinginbonds.com).

New issue bonds can offer real advantages for the ‘slow and steady’ portion of a portfolio. All major custodians and broker-dealers offer new issue bond platforms in the corporate and US Agency sectors.

John Radtke is the president of Incapital LLC, a securities and investment banking firm based in Chicago. Incapital underwrites and distributes fixed income securities and structured notes through over 900 broker-dealers and banks in the US, Europe and Asia.