Bonds or Bond Funds?

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Bonds or Bond Funds?
by James D. Peterson, Ph.D., Vice President, Investment Manager Research, Schwab Center for Financial Research
September 28, 2007

Reprinted from the September 2007 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

Allocating a portion of your investment portfolio to bonds can help you achieve stability and reduce risk over the long term. And for many retirees, bonds can also generate a nice source of steady income.

Whatever your reason for investing in fixed income products, you face a choice: individual bonds or bond mutual funds? There's no one correct answer—what's best for you depends on your personal investment needs.

If you seek professional management, greater diversification, solid credit oversight, automatic reinvestment of interest and ease of monitoring—and you can tolerate fluctuations in monthly income and investment value—consider bond mutual funds.
If you want a specific level of income, savings for a future liability at a known date, or active involvement in managing your portfolio—and you have enough to invest to adequately diversify—then consider individual bonds. You may need some initial help constructing your bond portfolio, but once that's done, it's fairly easy to monitor and maintain.

Of course, these are guidelines only. The choice between individual bonds and bond funds doesn't have to be an either-or decision. You may want a combination to meet your needs and objectives.

Key differences
Individual bonds offer regular, fixed income payments and maturity values that won't fluctuate. The market value of a given bond may fluctuate during its term (depending on changes in interest rates, overall credit quality of the issuer, etc.), but that will matter to you only if you need to sell on the secondary market prior to maturity.

Managing a portfolio of individual bonds is also more complex than managing an investment in bond funds. For example, if you plan on reinvesting coupon interest payments, you'll need to do so on your own with individual bonds, and the coupon payments may not be large enough to purchase another bond.

Bond funds, as mentioned above, tend to be simpler to monitor. However, income payments and principal values can fluctuate based on market conditions.

It's about diversification
The Schwab Center for Financial Research found that holding bonds from 10 or more issuers greatly improved portfolio diversification, with smaller benefits continuing with the more issuers you own. Even in a worst-case scenario, our research found 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 if you hold bonds with minimal default risk, such as AAA-rated issues or insured municipals. Bond funds are very unlikely to hold bonds from 10 issuers or fewer, because of diversification rules. In fact, corporate and municipal bond funds rarely own fewer than 30 issuers and often own hundreds.

Bond fund management companies also have credit research departments to provide oversight to their funds. It's difficult and potentially quite costly for retail clients to obtain the information necessary to perform credit oversight on a complete individual bond portfolio. And that oversight can be extremely important, as credit downgrades can send prices plummeting. In general, bond research isn't as readily available to retail investors as stock research is.

The costs of bonds and bond funds
Low-cost bond funds usually have management fees ranging from 0.3% to 0.6% per year. Generally speaking, at Schwab, you can construct a ladder of individual bonds at costs at or below those of a low-cost bond fund (though your costs may increase dramatically if you actively trade your bond portfolio or if the bonds being used are illiquid or of lower credit quality). For proper diversification, you'll generally need a minimum investment amount of $10,000 for a corporate bond portfolio ($1,000 per bond) and $50,000 for an uninsured municipal bond portfolio ($5,000 per bond).

What to Consider
If you …	Then consider:
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 fund redemptions
Seek predictable market value at maturity	Individual bonds that you can hold until their maturity dates

What's best for you?
Whether you're looking for steady income, lower volatility or greater portfolio diversification, bonds or bond funds can help. To determine which is right for you, you need to 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. For help in mapping out your fixed income investment plan, call your Schwab Consultant or our Fixed Income Specialists at 800-626-4600.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

Diversification does not eliminate the risk of investment losses.

A bond fund's net asset value will fluctuate with the price of the underlying bonds and portfolio turnover activity. Return of principal is not guaranteed. Bond fund shares are subject to increased loss of principal during periods of increasing interest rates.

When a bond is purchased or sold, Schwab charges a commission, markup or markdown. Individual bonds are subject to the credit risk of the issuer. Changes in interest rates can affect a bond's market value prior to call or maturity. Bonds are subject to credit, interest rate and inflation risks.

Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments and other factors.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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