Investing in Bonds: Should You Choose Individual Bonds or Bond Funds?
- Bonds can help stabilize your portfolio and reduce risk over the long term.
- Either individual bonds or bond funds, or a combination of both, can be used to help achieve these goals.
- These guidelines may help you choose.
Bonds can help stabilize your portfolio's volatility and reduce risk over the long term by balancing out riskier investments, such as stocks. For many retirees, bonds also serve as a source of income. But many investors wonder which to choose: individual bonds or bond funds?
What's best for you depends on your personal investment needs. In general:
Consider individual bonds if you want a specific level of income, savings for a future known date or active involvement in managing your portfolio, and you have enough to invest to adequately diversify. Individual bonds can help generate investment income, and are useful in cash flow planning, because they provide a predictable amount of cash when the bond matures.
- Consider bond funds if you seek professional management, greater diversification, credit oversight, access to areas of the bond market that you may lack the expertise to invest in on your own, the option to automatically reinvest interest payments, and ease of monitoring—and you can tolerate fluctuations in monthly income and investment value.
The choice between individual bonds and bond funds doesn't have to be an either/or decision. You may want to use both to meet your needs and objectives.
What are the key differences between individual bonds and bond funds?
- Individual bonds typically make regular coupon payments until they reach maturity at a date that is fixed in advance. The market value of the bond may fluctuate during its term, depending on changes in interest rates, overall credit quality of the issuer, and other factors. Assuming the issuer doesn't default—that is, fail to make coupon payments or to return principal, a risk known as "credit risk"—those fluctuations may not matter to you. You generally pay a trading fee when a bond is bought or sold, and individual bonds also can be more challenging to sell, as a buyer must be found in what can at times be a thinly traded, or "illiquid," market.
- Bond funds invest in a basket of bonds with varying maturity dates and yields. Bond funds typically don't have a set maturity date, because they often buy and sell bonds before they mature. Bond funds have no obligation to return your principal, and most pay income differently than individual bonds (monthly vs. semi-annually). Fund managers include a management fee, which you can find when researching funds. The price may vary from day to day, but is listed daily based on the fund's net asset value (NAV), the estimated daily market price of all bonds held in the fund.
For an individual investor, managing a portfolio of individual bonds can be more complex than managing an investment in bond funds. For example, if you plan on reinvesting coupon interest payments, you'll need to do this on your own with individual bonds, and the coupon payments may not be large enough to purchase another bond.
Bond funds tend to be simpler to monitor. However, income payments and principal values can fluctuate based on market conditions. A fund manager can seek to invest to manage changing interest rates, or can choose bonds in areas of the market that he or she believes have better return characteristics. It's also generally easier to automatically reinvest interest payments using bond funds.
What if interest rates rise?
In a rising-rate environment, the prices of both bonds and bond funds are likely to fall. If you plan to hold an individual bond to maturity, its price volatility may mean nothing to you. However, buying and holding comes with opportunity cost: If rates rise, you could miss out on the higher coupon payments offered by newer bonds on the market.
With a bond fund, rising rates are likely to prompt a short-term price drop. However, a fund manager can react to changing interest rates by buying and selling bonds to try to maximize coupon income. For instance, a manager may sell lower-coupon bonds and use the proceeds to buy bonds with higher coupons, or may reinvest the income payments from individual bonds into higher-yielding bonds. Over time, this may increase the income generated by the fund.
It's about diversification
The Schwab Center for Financial Research has found that holding investment grade bonds from 10 or more issuers greatly improved portfolio diversification. Those benefits continue, but at a diminishing rate, with the more issuers you own. Even in a worst-case scenario, our research found that a portfolio holding 10 issuers had one-fourth the expected principal loss of a portfolio holding just two issuers.
While we suggest a target of at least 10 different issuers, you may be comfortable holding fewer issuers if you hold bonds with minimal default risk, such as AAA-rated issues or insured municipal bonds. Bond funds are unlikely to hold bonds from 10 or fewer issuers because they generally have large sums to invest and benefit from diversification. In fact, corporate and municipal bond funds rarely own fewer than 30 issuers, and often own hundreds.
Bond fund management companies have credit research departments that provide oversight. If you own individual bonds, oversight can be extremely important, as credit downgrades can send prices plummeting. In general, bond research is less readily available than stock research to individual investors.
Costs of bonds vs. bond funds
Low-cost bond funds usually have management fees ranging from 0.3% to 0.6% per year, or lower. Generally speaking, you may be able to construct a ladder of individual bonds—that is, multiple bonds with different maturity dates—with a transaction fee at or below that of a bond fund. However, bond fund managers can often purchase bonds in larger blocks with more attractive pricing (known as bid/ask spreads) than an individual investor. For proper diversification and efficiency, you'll generally want a minimum investment amount of $100,000 for a corporate or uninsured municipal bond portfolio ($10,000 per bond).
A few rules of thumb
Are a new investor or have a small dollar amount allocated to bonds
Bond funds (better diversification bang for fewer bucks)
Want to use an automatic investment plan
No-load, no-transaction-fee bond funds
Lack time to research and monitor individual bonds
Bond funds (for professional management)
Need a specific level of income
A ladder of individual bonds
Don't want to incur unnecessary capital gains
Individual bonds (to avoid capital gains resulting from sale of bonds in the fund)
Seek predictable market value at maturity
Individual bonds that you can hold until their maturity dates
What to do now?
Whether you're looking for steady income, potentially lower volatility or greater portfolio diversification, bonds or bond funds can help. To determine which is right for you, you must first fully understand your attitude toward risk and diversification, as well as how much money you wish to allocate toward bonds over a specific time horizon.
When you're ready to take the next step, Schwab's online research tools and expert picks on bond funds can help you make more informed fixed income investment choices. For one-on-one help in mapping out your fixed income investment plan, reviewing your existing plan or choosing new investments, contact your Schwab Financial Consultant or call a Schwab bond specialist.
Talk to Us
To discuss how this article might affect your investment decisions:
- Call a bond specialist at Schwab anytime at 877-908-1072.
- Talk to a Schwab Financial Consultant at your local branch.
Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by visiting Schwab.com or calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).
Past performance is no guarantee of future returns.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.