Individual Bonds vs Bond Funds
There is no denying that adding bonds to your investment portfolio is quickly growing in popularity.
However, it is important to understand that there are different ways in which to purchase bonds, and each has its own benefits and disadvantages.
Additionally, you will need to choose the option that works best with your chosen risk level, how much you have to invest, whether you will track those investments properly and your own ability to do the research for your initial investments.
Individual bonds offer an investment option that allows you to purchase a return at a fixed return or yield rate.
With individual bonds, your return depends on the overall length of the bond period and whether or not the issuer pays the entire principal of the loan along with the interest payments.
These types of bonds also require you to scrutinize the creditworthiness of the company to determine whether the potential earnings are worth the risk.
Bond funds, which are often referred to as bond mutual funds or bond ETFs, provide a way for investors to invest in a variety of bonds rather than a single entity at a time.
These types of investments offer a variety of advantages and disadvantages.
Advantages of Bond Funds
Bond funds offer a much more diverse portfolio option. This diversity minimizes the reliance on a single security, which means that if a chosen option does poorly, it won’t necessarily affect the overall earnings potential of the entire portfolio.
Many investors in bond funds also find that there is added security in having the portfolio managed by professionals. Bond funds are always managed by SEC-registered investment advisors that have the knowledge needed to know which securities to purchase and when to sell them.
Bond funds also offer greater convenience and flexibility over individual bonds. Investors can change funds within the same managing company, which provides a free rebalancing tool to ensure the best overall potential for earnings within the portfolio.
Bond mutual funds are also more liquid than other options as they must be redeemed at a specified time based on the net asset value (NAV). Any redemption requests must be paid within seven days, providing a much faster means of gaining income when necessary.
Disadvantages of Bond Funds
While there are many benefits to investing in bond funds, you also need to be aware of the disadvantages.
One of the most important of these is the amount of expenses and fees associated with the overall cost. While the largest of these is the ongoing management fees, the sales and redemption charges and expense fees also add considerably to the cost.
A risk is also elevated with bond funds.
You would assume that bond funds would share the protective properties of actual bonds, but you would be wrong. Investing in bond funds can put your principal at risk.
Finite maturity is the hallmark of individual bonds. No matter what type of individual bond you’re holding, corporate, municipal or treasury, you know when you’ll get your principal back, so long as the issuer does not default. You can plan for the date when you will stop earning interest.
Bond funds are different – they have a staggered trip toward maturity. The fund manager replaces them as the issuer calls them in, as they mature, or as the issuer’s credit is downgraded. That fosters consistent payment delivery, but you do not have a set maturity date. You’re not able to plan effectively, and there is little certainty as to when you’ll break even.
Bond funds could potentially be in a state of decline for many years should FED begin to rise rates, resulting in a significant loss.