Better Ways to Invest in Bonds?

By Preston McSwain and Ryan Larson, CFA, CAIA, October 2, 2026

Why Bond Fund Investing May Be The Smarter Choice

A debate has run for years in fixed income investing.

Should investors hold low-cost bond funds, or should they build portfolios of individual bonds through separately managed accounts (SMAs)?

Proponents of SMAs largely tout customization and the ability to hold individual bonds to maturity.

Advocates of low-cost funds emphasize broad diversification, simplicity, and lower expenses.

Our view is that for the vast majority of investors, low-cost funds are the better choice.

The following are the points that make this case.

Fees Seen

The easiest advantage to see is fees.

Bond fund fees can be as low as 5 basis points per year.

In contrast, fixed income SMAs commonly charge 25 to 50 basis points – five to ten times more.

The differential is roughly 20 to 45 basis points before a single bond has been traded.

This may not sound like a lot until you consider that in fixed income investing, the difference between a top quartile return and a bottom quartile return can be 50 basis points or less.

Expenses Unseen

Another important factor in fixed income investing is trading costs.

No central bond exchange exists.

Bonds are bought and sold among trading desks, whose job it is to maximize profit in terms of markups on bonds they may hold themselves or be buying from another desk before passing them along to a buyer.

The larger and more sophisticated the buyer, the more buying power they have.

Large bond funds have a significant advantage here. They can negotiate or demand a lower price when buying large quantities of bonds.

These costs are not seen, but they can be significant.

One study found that retail investors can pay as much as 2% more for a bond than a larger, institutional buyer. And, these high haircuts can happen on both a buy and a subsequent sell, if needed (more on this below).

SMA bond managers are sophisticated and get better execution than investors who buy or sell bonds on their own from brokers.

But…

Unless the separate account portfolio is quite large – into or near the million dollar range per bond – the bonds being bought and sold are below institutional size.

As with most things, a larger bulk buyer gets a better price – bond desks charge lower markups as a percentage of a bond’s cost on a $1,000,000 bond than on a $100,000 bond.

Translation…

Caveat SMA investor.

Unseen SMA costs can reduce returns more than you think.

Diversification

Diversification is the foundation of prudent investing, and in fixed income its benefits are particularly important.

Fixed income returns are asymmetric. If all goes perfectly, an investor receives back the purchased yield at maturity, after the issuer repays the amount borrowed. That is the maximum return.

The downside can be large, however, if an issuer defaults, misses an interest payment, or fails to repay the full amount at maturity.

Thus, concentration is punished more harshly in fixed income than in equities, where upside can be large.

Investors in bond funds can hold literally thousands of bonds (some bond index funds can hold into the tens of thousands), so the failure or downgrade of any one bond has minimal effect on the portfolio.

By contrast, SMAs commonly hold fewer than 100 bonds, and it’s not uncommon to see portfolios own fewer than 25.

Combined with the unseen trading costs above, the problem compounds.

Say an SMA manager has a $10,000,000 portfolio to manage, which would be large by most individual investor standards.

To get best execution in terms of lower markups, the manager ideally would be buying in sizes that approach $1,000,000 per bond. That would allow only 10 holdings, though, so they may buy $100,000 positions to improve diversification.

As mentioned in the previous section, high unseen costs for the diversification of your separate account can equal lower returns.

Liquidity

SMA providers will tell you that a portfolio is liquid, and in a sense they are right. Bonds are liquid instruments.

The question is the price you pay for liquidity when you need it.

Consider an investor who needs to withdraw a meaningful sum from an SMA. The manager cannot sell a slice of the portfolio the way a fund shareholder redeems a proportional interest in thousands of positions. The manager has to sell individual bonds into a dealer market where the buyer knows they need to sell quickly.

A dealer who knows the seller needs to sell has significant leverage on the markup or, in this case, the markdown (see the reference to the 2% haircuts above).

Managers can work to trade bonds over multiple days to improve pricing, but depending on when the funds are needed and the sizes of the positions, dealers will price accordingly to maximize their profit.

Next, once the trades are done, the investor is left with a portfolio that is smaller, more concentrated, and less balanced than the one they started with.

Additional trades to restore the portfolio’s original structure can be made, however, this starts the cycle of return-reducing markups all over again.

By contrast, a fund shareholder redeeming the same dollar amount sells a proportional interest in the entire portfolio at a single price. The remaining portfolio is similar, if not identical, to what it was the day before. There is no repair trade, because nothing was broken.

The SMA is liquid. It’s holdings can be sold.

The question is at what price.

The Maturity Fallacy

One of the most common justifications, or selling points, for individual bond portfolios is that an investor can hold the bonds to maturity and thereby avoid interest rate risk.

What often goes undisclosed is this…

An SMA portfolio that holds individual bonds is no different than a bond fund portfolio that holds individual bonds. Both are bond portfolios.

The difference is transparent pricing, and the costs and emotions behind it.

Bond funds provide transparency by pricing the bonds they hold each day and reporting those prices as daily returns.

SMA managers can do the same, and some do. The pitch that you are better off with portfolios of individual bonds suggests that they are not.

All bonds fluctuate in price daily, whether held in a fund or in a separate account.

As Cliff Asness of AQR points out in his Top 10 Pet Peeves piece…

“Bond funds are just portfolios of bonds marked to market every day. How can they be worse than the sum of what they own?”

Ladders Don’t Change the Math

A related claim is that investors are better off building their own SMAs by laddering – buying individual bonds of different maturities and holding them to maturity.

What an investor is really doing, though, is creating their own SMA and becoming their own portfolio manager.

As Cliff Asness also states in his Pet Peeves…

“Investors in individual bonds typically reinvest the proceeds of maturing bonds in new long-term bonds (often through the use of a laddered portfolio). In other words, their portfolio of individual bonds, each of which individually has the wonderful property of eventually maturing, never itself matures. Again, this is precisely like the bond funds that they believe they must avoid at all costs.”

Back to unseen costs, laddered investors are even at risk of being marked up by what the industry calls retail trading desks.

These bond distribution sales teams don’t call themselves retail of course – they often go by names such as Private Banking Wealth Managers or Advisors.

Make no mistake, however, they are in the business of making profits on marking up bonds and selling them to investors who have little to no transparency on the actual institutional price.

Also, it’s good to keep this in mind…

Investors may be marked up twice, as some retail desks are marked up by their own institutional desks, whose job it is to maximize profits on the sales of bonds to retail divisions.

None of this means the appeal of individual bonds is imaginary.

Not watching a position fluctuate may well produce calmer behavior, and calmer behavior has real value.

Again, it’s all about what you may pay for it in higher fees and lower returns.

Why We Prefer Low-Cost Bond Funds

In writing this piece, we aren’t suggesting that all bond SMAs aren’t appropriate. The circumstances justifying can just be more costly and narrower than their pitches imply.

As an example, they might make sense when an investor already holds individual bonds or an existing SMA. As those bonds mature, we suggest moving into bond funds but, during a transition, it may be prudent to hold legacy bonds in a low-fee separate account rather than incur taxes on sales or markdown transition costs to make a wholesale change up front.

Separate accounts could also make sense for institutional portfolios in the hundreds of millions with a specific mandate, such as a socially responsible screen or restriction. Even then, though, many types of bond funds exist, and costs may be lower and diversification greater with a low-cost fund.

Bottom-line…

Investing should be about returns net of fees, not about optics or narratives.

Being able to see the maturity date on a bond does not make it a better deal.

Not seeing what you paid in a buy markup or sell markdown compounds the risk of getting a bad one.

Low-cost bond funds deliver the following: