When it comes to fixed income investing, there are two options available to investors. You can own individual bonds, or you can purchase shares of a bond fund. Both options have unique advantages and disadvantages that make them suitable under certain conditions.
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We’ll begin by summarizing the differences between bond funds and individual bonds, and then we’ll list out the pros and cons of each.
Understanding the Difference
Owners of individual bonds receive a commitment from the issuer to receive predefined interest payments, usually semi-annually, and a return of their principal upon maturity of the bond. As long as the issuer doesn’t default, bond owners can count on this reliable income stream. Knowing exactly how much income you will receive, the corresponding rate of return you are earning, and that you will receive your principal back when agreed, makes individual bonds attractive for their transparency.
Bond funds, on the other hand, are a completely different animal. Purchasing shares of a bond fund is technically still considered fixed income investing, but the nature of these funds poses additional considerations and complicates your investment considerably.
When you purchase a bond fund, you are pooling your money with other investors and allowing a professional money manager to purchase, hold and sell bonds on your behalf. Different bond funds have different investment strategies, but all bond funds share some similar characteristics.
To begin, most bond funds hold a variety of bonds that mature at different times. This allows the bond fund to make periodic payments to its shareholders, distributing the income that the bond portfolio generates. While these distributions are designed to mimic the periodic interest payments of owning individual bonds, they can fluctuate based on the performance of the bond fund.
Another critical aspect to understand about bond funds is that there is no maturity date upon which you can expect to recoup your initial investment. Said differently, there is no assurance of getting back 100% of your principal. When you invest in a bond fund, you are purchasing shares. The price of these shares will fluctuate based on a number of factors. If you decide you want your money back, your only course of action is to sell your shares at whatever the going price is.
Now that you have a basic overview of the difference between owing individual bonds and a bond fund, let’s go through the pros and cons of each.
- Predefined interest payments – The amount and timing of interest payments is known and established beforehand. This can be very beneficial for investors who rely on these interest payments to pay for certain expenses.
- Known rate of return – You know exactly how much your investment is going to earn before the investment is made. This does not apply to floating-rate bonds or if you do not hold the bond to maturity.
- Guaranteed return of principal – As long as the issuer doesn’t default, you can rest assured that you will receive your initial investment back upon maturity of the bond.
- Selling bonds prior to maturity can be difficult – This is generally not the case with Treasuries and high-grade corporate bonds, but some types of bonds such as municipal bonds have thinner and less liquid markets.
- If you sell before maturity, there is no guaranteed return of principal – The price of a bond fluctuates constantly based on a number of factors. If you need to sell beforehand, you could receive less than what you initially paid.
- Diversification can be difficult – Just as with stocks, diversification of bonds in very important. Smaller investors may have difficulty achieving a healthy level of diversification through individual bonds.
- You are responsible for managing your investments – It’s up to you to understand the financial stability of the issuer and determine if the return is reasonable for the amount of risk you are taking. If you stick to Treasuries and high-grade corporate bonds, this risk is generally minimal. Higher yielding bonds contain more risk.
- Transaction costs – You will pay a markup to the dealer from which you purchase your bonds.
- Professional management – Bond funds are generally run by professional bond investors, or designed to track benchmark bond indexes. A good manager can shift holdings accordingly to manage changing financial conditions.
- Easy to achieve diversification – Even a small investment in a bond fund becomes instantly diversified.
- Easy to sell your position – You can liquidate your position just as easily as selling shares of a stock.
- Subject to increased levels of interest rate risk – If market interest rates rise, the value of all bond funds will decline. This could leave your investment worth less than what you initially paid.
- Periodic interest payments are not guaranteed – Depending on market conditions and the performance of the bond fund, the amount returned to shareholders in the form of dividends can vary. This can be an unattractive feature to those who require the income to pay for certain expenses.
- Annual expense ratio – You will pay an annual fee, called an expense ratio, for participation in a bond fund. These vary from fund to fund and can be minimized by using exchange-traded funds (ETFs) rather than mutual funds.
Knowing the benefits and drawbacks of each approach to fixed income investing will enable you to make the best decision for you particular situation. But before you decide between individual bonds or bond funds, make sure that the current investment climate is one that is favorable to bond investors. Many investors don’t realize that bonds investors can be subject to the same magnitude losses as stock investors.