The case for bonds is likely familiar to most investors. If a portfolio were a ship, bonds would be the ballast—providing a measure of stability. They’re a counterbalance to riskier investments like stocks, and can help you manage volatility over time. And because bonds can also provide steady, predictable cash flows, they’re useful for income planning in retirement.
Less clear perhaps is the best way to add bonds to your portfolio. Do you buy individual bonds? Bond funds? Some combination of the two?
In general, both bonds and bond funds provide income and diversification from stocks. But it’s worth weighing the differences before you choose.
As with any investment, what works best for you will depend on your preferences, your goals and your response to different kinds of risk. So let’s take a closer look at some of the key qualities of bonds and bond funds and consider some situations where one or the other might make sense.
Most investors are drawn to individual bonds because of the reliable source of income they provide. Bonds are issued by governments, businesses and other organizations, and usually make interest payments for a set number of years. When you buy a bond, you generally receive an interest payment every six months and then the bond’s face value, or principal, when it matures.
Bonds’ regular payments and predetermined lifespans make them appealing for people who want to plan for predictable cash flows. If you know you’ll need a certain amount of money each year or would like to recover your principal at a certain date, bonds can be very useful.
The market value of the bond may fluctuate throughout its life, depending on changes in interest rates, overall credit quality of the issuer and other factors. However, you receive a set promised “par” amount when the bond matures. When you buy a bond, you may pay a commission and a markup on the price of the bond (the difference between the dealer’s purchase price and the price at which it is sold to the investor).
A risk with bonds is that the issuer might miss a payment, or even fail to return the principal (known as default). Historically, these problems are rare for bonds with high credit ratings from a major rating agency, 1 but you should still pay close attention to the issuer’s credit quality.
Some bonds can also be redeemed, or “called,” prior to maturity. In this case, you would receive the call price, which is set when the bond is issued and could be less than the price you paid for the bond. If you wanted to replace the lost income, you might find that interest rates on new, comparable bonds are lower.
Investors in individual bonds should also consider these features:
- Diversification. Research by the Schwab Center for Financial Research found that holding investment-grade bonds from 10 or more issuers greatly improved portfolio diversification. That can mean investing $100,000 or more to build a diversified corporate or municipal bond portfolio (assuming $10,000 per bond). Your portfolio shouldn’t have too much exposure to a particular issuer, sector or type of bond. Also, make sure you understand each issuer and each bond to see they match your goals and risk tolerance.
- Liquidity. If you should need to liquidate a bond before it matures, it can sometimes be challenging to find a buyer. Some types of bonds can be thinly traded at times, and there’s no guarantee that someone will want to buy a bond at the price you are asking for it.
Bond mutual funds hold multiple bonds and can be managed either actively by an investment manager or passively to replicate an index, such as the Barclays U.S. Aggregate Bond Index.
Bond funds can also focus on broad or narrow parts of the market. But in general, holding multiple bonds adds a level of diversification, because multiple bonds involve multiple issuers and maturities. For example, corporate and municipal bond funds rarely limit their holdings to fewer than 30 issuers, and often own hundreds. It can be difficult for investors to replicate this diversification with individual bonds.
Shares are valued based on the fund’s net asset value (NAV), which is basically the value of all its bond holdings divided by the number of fund shares in circulation. Shares in the fund can rise or fall a little each day according to the fund’s NAV. However, monthly income payments to fund investors are generally the main source of return for bond fund holders. (Bond funds typically make payments to investors monthly rather than every six months, as individual bonds do).
Bond funds trade on a regular exchange, so you know the price you’ll receive if you need to sell shares in a bond fund on any given day. The fund’s management fee can be found in its prospectus. As an example, low-cost bond funds usually have management fees ranging from 0.3% to 0.6% per year. Passively managed funds, including many exchange-traded bond funds, can have even lower management fees.
Bond fund managers may be able to buy bonds at better prices than an individual investor because they buy larger blocks. And bond fund management companies may also have dedicated research departments that handle security selection and monitoring, which can be particularly helpful if an investor wants access to an unfamiliar or complex part of the market.
Another potential advantage bond funds have over individual bonds is that they may make it easier to set up automatic investment plans and reinvest interest payments. With a no-load, no-transaction-fee bond fund, you can regularly contribute smaller amounts to build your investment over time, whereas building up an investment in higher-cost individual bonds might be more difficult.
Some other considerations:
- Fund prices and yields move constantly, so your income may fluctuate. Again, market conditions and changing holdings can affect the value of fund shares.
- Most funds don’t mature, so you don’t receive a promised set amount at a future date. If you need to sell your fund shares when markets are down, you could face losses.
- Funds are always buying and selling bonds, which can affect your taxes. Fund managers pass capital gains or losses on to investors.
What if interest rates rise?
When interest rates rise, bond prices fall. If you own individual bonds and are planning to keep them until they mature, this may not concern you. Barring a default, you’ll continue to receive interest payments and then the principal promised “par” amount at maturity. The only consideration might be the opportunity cost of not being invested in new, higher interest-rate bonds.
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.
Be aware, though, that if you need to sell a bond fund during a period when rates rise, the value of the fund may be lower than the price when you purchased the fund. Short-term bond funds tend to be less sensitive to changing interest rates than other types of bond funds, so consider those—or other, less volatile investments—if you think you may need to sell shares in a bond fund soon.
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, think first about your attitude toward risk, how actively you want to participate in managing your portfolio and how much you’d like to invest.
And remember, this doesn’t have to be an either/or decision. The relative predictability of individual bonds can make sense in lower-risk areas of the market, such as Treasuries, municipal bonds and investment-grade corporate bonds. The easier management and diversification possible with bond funds can be appealing in areas where risks are higher, like high-yield/subinvestment-grade corporate bonds and international bonds. You may find that combining the two can help you meet your goals.
1 Standard & Poor’s “2014 Annual Global Corporate Default Study,” 4/30/2015 and Moody’s “U.S. Municipal Bond Defaults and Recoveries, 1970–2014,” 4/24/2015. Moody’s and Standard & Poor’s rating agencies define “high credit rating” as a rating of Aaa/Aa1/Aa2/Aa3 and AAA/AA+/AA/AA-, respectively.