Which are better: bonds or bond funds? As a fixed income strategist, I’m probably asked this question more than any other. The answer depends on one’s goals and tolerance for risk. Here’s a look at how the two investments differ—and when one might make more sense than the other.
Many investors are drawn to individual bonds because of the reliable income they provide—namely, set interest payments (typically every six months) and a date on which the principal is paid back.
That said, there are a number of uncertainties when it comes to individual bonds:
Call risk, or the chance that a bond could be redeemed, or called, by the issuer prior to maturity—at which point you would receive the predetermined call price, an amount that could be less than what you paid.
Default risk, or the likelihood that the issuer will be unable to return a bondholder’s principal. This is rarely the case for bonds with higher credit ratings but is a risk nonetheless.
Interest-rate risk, or the effect of rate increases on a bond’s market value. If you plan to hold a bond until it matures, you will receive its face (or par) value regardless of prevailing interest rates; however, if you sell before it reaches maturity, higher interest rates can negatively impact a bond’s price.
Adequate diversification is another issue. The Schwab Center for Financial Research recommends holding investment-grade bonds from at least 10 issuers to achieve adequate diversification, which can require a significant initial investment.
There are several advantages to the ubiquitous investment vehicles known as bond funds:
Cost: Because they buy in bulk, fund managers often have access to better prices than those available to individual investors.
Diversification: Corporate- and municipal-bond funds, for example, rarely hold fewer than 30 issuers, and commonly own hundreds, so adequate diversification is frequently part and parcel of any bond fund.
Know-how: Fund managers regularly employ dedicated research departments, which can be particularly helpful when accessing unfamiliar or especially complex parts of the market.
What’s more, it can be easier to reinvest interest payments and set up automatic investment plans with bond funds than with individual bonds. With no-load, no-transaction-fee funds, you can also regularly contribute smaller amounts to grow your assets over time, which is advantageous to those who don’t have the funds on hand to build a diversified portfolio of individual bonds from scratch.
Of course, bond funds also have their shortcomings. Chief among them:
Potential loss of principal: Because most bond funds don’t mature, you generally won’t see your principal investment returned to you on a set date; rather, you’re subject to the vagaries of the market and so could suffer losses in a downturn.
Unpredictable income: Unlike the predictable income generated by most individual bonds, the income from bond funds rises and falls along with interest rates and the value of the funds’ underlying holdings. Be that as it may, fund managers frequently compensate by buying and selling bonds to maximize income, and those looking to sell in the near future should note that short-term bond funds tend to be less sensitive to changing interest rates.
Unpredictable taxes: Fund managers frequently buy and sell bonds and pass capital gains on to investors, which can negatively affect your tax bill.
For those looking for exposure to investment-grade corporate bonds, municipal bonds, U.S. Treasuries and other lower-risk areas of the market, the relative predictability of individual bonds can make the most sense. For those looking to access high-yield and international bonds and other areas of greater risk (and potential reward), the professional management and diversification offered by bond funds can be a significant advantage. And for those wanting a mix of relatively safe and relatively risky investments, combining the two vehicles can provide an optimal middle ground.