When investing in bonds, two common avenues are buying bonds directly Over the Counter (OTC) or buying bond Exchange-Traded Funds (ETFs). Both methods offer exposure to fixed income markets but differ significantly in terms of how they function, the risks involved, and the benefits they provide. This article explores these differences to help investors make informed decisions.
Direct Bond Purchases via OTC
The OTC bond market is where individual bonds are bought and sold directly between parties without a centralised exchange. Traditionally, the OTC market in Australia had been limited to institutional investors due to large minimum transaction size, however, improvements in technology and the ability of providers like NAB Private Wealth to provide more marketable parcels has opened up the space to wholesale investors.
According to the World Economic Forum the global bond market is valued at over US$130 trillion. It provides a wide selection of government and corporate bonds, as well as hybrids. The Australian market is valued at over US$2 trillion, and despite its relatively small size it is still the primary source of fixed income solutions for many Australian investors.
Key characteristics:
- Customisation: Investors can choose specific bonds based on their preferences (e.g., maturity date, yield, credit rating) allowing them to have more control when building a tailored portfolio.
- No intermediary layers: By purchasing a bond directly, investors know the exact bond they are buying, and the terms associated with it.
- Settlement: OTC bond transactions are generally settled between the buyer and seller directly, with the bond issuer playing no role in the trading process.
Benefits of Buying Bonds OTC:
- Greater control: Investors can select bonds that align with their goals, such as those from specific issuers or regions, with certain maturities and yields.
- Predictability of income: Direct bond purchases give a clearer understanding of the expected coupon payments and principal repayment at maturity.
- Customisable portfolio: Investors have full flexibility to build portfolios tailored to their risk tolerance and investment horizon.
Considerations for OTC bonds:
- Less liquid: Potential for less liquidity compared to shares or ETFs, meaning they may be harder to buy or sell especially in times of market stress.
- Price transparency: Given the lack of a centralised exchange, bond prices in the OTC market are often not transparent, and therefore makes it difficult for retail investors to compare prices.
- Higher transaction costs: Bid-ask spreads in the OTC market can be wider, and transaction costs might be higher due to lower liquidity and fewer market participants.
Also read: New Ethical Australian Fixed Income ETF
A path for retail investors
Bond ETFs are investment vehicles that hold a diversified portfolio of bonds and are traded on an exchange like shares. They are commonly used by retail investors seeking a fixed interest exposure. These ETFs can hold various types of bonds, such as government and corporate bonds, depending on their investment mandate.
Key Characteristics:
- Diversification: A single bond ETF holds multiple bonds, providing diversification across issuers, maturities, and credit qualities.
- Liquidity: ETFs are traded on stock exchanges, offering greater liquidity compared to OTC bond transactions.
- Transparency: Prices of ETFs are readily available throughout the trading day, with live market pricing and published holdings available regularly.
Benefits of Buying Bond ETFs:
- Diversification: Bond ETFs spread risk across many different bonds, lowering the impact of any one bond’s default or downgrade on the overall portfolio.
- Lower cost: Bond ETFs generally have lower expense ratios compared to purchasing individual bonds, as they pool investors’ resources to reduce costs.
- Liquidity and accessibility: Bond ETFs are easy to trade on exchanges during market hours, allowing investors to buy or sell at known market prices, often with narrow bid-ask spreads.
- Simplified management: ETFs are passively managed, so investors do not need to continuously monitor and adjust their portfolios as individual bonds mature.
Considerations for Bond ETFs:
- No guaranteed principal repayment: Unlike holding individual bonds to maturity, where the principal is repaid at the end (subject to the issuer not defaulting), bond ETF prices fluctuate and may result in capital loss if sold during a downturn.
- Lack of customisation: Investors do not have the ability to select securities or adjust the make-up of an ETF based on their individual preferences.
- Tracking errors: Although bond ETFs aim to track their underlying bond indices, they may not perfectly replicate performance due to factors such as fund expenses, sampling techniques, or illiquidity in the underlying bonds.
- Additional costs: Although the fees are typically low, investors still need to account for management fees, which can reduce overall returns over time.
Choosing Between OTC Bonds and Bond ETFs
The choice between buying individual bonds OTC and purchasing bond ETFs comes down to personal preference. Investors should weigh up the benefits and risks and decide based on what suits them.
For control and predictability: Investors who prioritise control over the specific bonds they own and desire fixed income streams, may prefer the personalisation offered by the OTC bond market. This method may be right for those seeking a tailored exposure, such as buying bonds with specific maturities or credit ratings.
Bond ETFs may be better suited for investors seeking easy market access, broad diversification, and liquidity. Investors who do not want to deal with the complexities of bond selection and prefer to invest with lower transaction costs may favour ETFs.
Conclusion
Both OTC bonds and bond ETFs offer pathways to bond market exposure, but they cater to different investment needs. OTC bond purchases provide greater control and predictability for those who seek to manage specific bonds, while bond ETFs offer liquidity, diversification, and convenience at a lower cost. Investors should assess their individual goals, risk appetite, and market knowledge before choosing the most suitable option for their portfolios.
