Are Individual Bonds Or Bond Funds A Better Investment?

Introduction

Are individual bonds or bond funds a better investment? Bonds are an important part of an investment portfolio. Maybe you’ve heard of a 60/40 portfolio. In general, this describes an investment with 60% stocks and 40% bonds. Commonly, this proportion of stocks and bonds represents a moderate allocation.

Bonds are often considered to have a lower risk profile than stocks. While that isn’t always the case, adding bonds to a portfolio generally reduces risk. So, the greater the amount of bonds the more conservative an allocation becomes.

How you add bonds to your portfolio is the tricky part. Typically, your investment choices will be individual bonds, actively managed bond mutual funds, or index bond exchange traded funds or ETFs. In this article, we’ll compare these investment vehicles to help you determine which is right for you.

What Are Bonds and Bond Funds?

Bonds

Bonds provide a way for companies to borrow money. The company issues a bond for a set time period and interest rate they will pay the bond holder (the investor). As the investor, you are receiving a promise from the company or government institution that they will pay you interest and the principal (amount you invested) at the end of the term.

Because of this arrangement, bonds are more secure than stocks because the investor has become a creditor of the company or institution. This contrasts with owning stock as a shareholder where you are last in line if the company goes bankrupt.

Bond Funds

For this discussion, we’ll focus on the two main types of bond funds which are mutual funds and ETFs. Both allow an investor to gain exposure to the bond market without having to pick the individual bonds themselves.

Instead, the investor gives their money to a bond fund manager who pools investors capital and selects the individual bonds. This is like stock mutual funds. As an investor in the fund, you will receive interest payments and broad diversification. Additionally, you have outsourced the research and trading responsibilities to a professional.

For a deeper dive on the details, please visit my article Bond Mutual Funds – What You Need To Know.

Key Factors to Consider for Long-Term Investment

Identifying your risk tolerance key. For example, if you aren’t comfortable with risk, you should probably avoid high yield bonds (a.k.a. junk bonds). Alternatively, higher risk tolerance investors likely don’t need to focus solely on U.S. government bonds.

Clearly understanding your time horizon will help you avoid some pitfalls. If you anticipate needing to access your funds within 12 months, you may want to avoid bonds or funds that invest in long-term maturities.

The interest rate environment and market conditions are important to consider. The value of bonds move inversely to interest rates. If rates are rising, the value of bonds will decline. If rates are headed down, the price of bonds will generally rise.

Advantages and Disadvantages

Bonds

There are some good reasons to own individual bonds.

First, owning an individual bond allows for more predictable returns. The interest rate specified on the bond tells you exactly how much you will receive in interest payments and when.

Second, because there is a fixed maturity date, you’ll know exactly when the principal will be paid back to you.

Finally, once you’ve paid the broker commission to buy the individual bond, there are no recurring fees so costs can be low.

There are some disadvantages as well.

First, unless you’re buying a significant number of bonds from different issuers and in different markets, you will likely have a diversification problem. This means you’ll be overly exposed in the event of default on the bond by the issuer.

Second, buying and selling individual bonds isn’t as easy as it is for stocks. The bond market isn’t as liquid and transparent as the stock market. The bottom line is that you may not be able to sell your bond when you need to or for the price you want.

Bond Funds

There are several advantages for owning bond funds.

First, bond mutual funds and exchange traded funds allow for immediate diversification. The fund could have exposure to hundreds or thousands of different bonds from a variety of issuers.

Second, selling your bond fund is easy because the mutual funds and ETFs are much more liquid.

Lastly, funds allow access to a professionally managed portfolio.

There are some drawbacks to consider.

First, there is no fixed maturity date for funds. They are mostly open ended.

Second, if your fund manager makes mistakes and selects poorly performing bonds, your returns will suffer.

Lastly, the professional management isn’t free. If it’s an actively managed mutual fund, you can expect to pay ongoing management fees which can eat into your profits. However, this isn’t as much of a concern for index exchange traded funds or ETFs since they are primarily tracking an index.

When to Choose Individual Bonds or Bond Funds

Going with individual bonds is better for individuals who are seeking stable income and utilizing a ladder strategy. This is where you buy various bonds with different maturities to reduce against interest rate risk. If you have a significant amount of assets and have access to a broker who can facilitate the buys and sells for a reasonable cost, this may be the way for you.

Bond funds should be considered for those placing an emphasis on diversification and liquidity, or the ability to easily convert to cash. Additionally, outsourcing the management responsibility to a professional in the bond market space can help bring peace of mind.