Bonds vs. bond funds: Which is right for you?

Bonds and bond funds are two popular investment vehicles that offer income and potential capital appreciation. While both involve lending money to entities like governments or corporations, they differ significantly in terms of cost, management and accessibility.

How investing in bonds works

A bond is essentially a loan you make to an entity, such as a government or corporation. In return for lending your money, you receive regular interest payments (coupons) and the principal amount back when the bond matures. Bonds typically have a fixed maturity date, ranging from a few months to several decades.

To invest in individual bonds, you typically need to purchase them through a brokerage account. You can buy bonds directly from the issuer, but this is often limited to large institutional investors.

Unlike stocks, bond prices are primarily influenced by interest rate fluctuations rather than company performance. A bond’s fixed interest payment remains constant throughout its term, regardless of price changes. However, the bond’s yield, calculated by dividing the coupon payment by the bond’s market price, fluctuates inversely with the bond’s price. When bond prices rise, yields decrease and vice versa.

This interplay between bond prices and yields is a key factor for bond investors to consider. A bond’s time to maturity, the issuer’s creditworthiness and overall market sentiment also impact its price.

Benefits of bonds

• Predictable income: Bonds offer a steady stream of income in the form of coupon payments.
• Principal return: At maturity, you receive the full face value of the bond.
• Lower risk: Compared to stocks, bonds are generally considered less risky investments.

How investing in bond funds works

A bond fund is a pool of money collected from multiple investors to purchase a variety of bonds. Professional fund managers select and manage the bonds within the fund or, in some cases, track a passive bond index. As a shareholder, you own a portion of the fund’s holdings.

Investing in bond funds is generally easier than investing in individual bonds. You can purchase shares of a bond fund through a brokerage account with a relatively small initial investment. Bond funds offer diversification, as they invest in multiple bonds, reducing the risk associated with any single bond defaulting.

Bond funds also offer a wide range of options for investors. Some funds aim to replicate the entire bond market, while others focus on specific segments, such as high-yield bonds or short-term bonds. Each type of bond fund responds differently to interest rate changes. By incorporating bond funds into a primarily stock-focused portfolio, investors can generally reduce overall volatility.

Benefits of bond funds

• Diversification: Bond funds spread your risk across numerous bonds, reducing the impact of any single bond underperforming.
• Professional management: Fund managers handle the task of bond selection and trading.
• Liquidity: You can typically buy and sell shares of a bond fund more easily than individual bonds.
• Accessibility: Bond funds often have lower minimum investment requirements than individual bonds.

Individual bond vs. bond fund: Key differences

There’s no one right answer when you’re deciding between individual bonds and bond funds. Ultimately, the decision usually comes down to how much money you have to invest and the amount of time you’re willing to spend building your bond portfolio.

Here are some key differences to keep in mind when deciding between these two investments.

Investment management

With individual bonds, you’re responsible for researching and selecting specific bonds that align with your goals. This requires in-depth analysis of the bond issuer’s creditworthiness, as well as ongoing monitoring of market trends.

This do-it-yourself approach can be rewarding if you enjoy the research process and want full control over your fixed-income portfolio. However, it also demands a big time commitment and a strong understanding of the bond market.

Bond funds, on the other hand, delegate investment management to professional fund managers or passively track a bond index. These experts manage the fund’s holdings, making investment decisions based on the fund’s specific objectives.

This approach can be a good fit for investors who are looking for convenient diversification. Some popular bond funds include Vanguard Total Bond Market ETF ( BND ) and iShares Core U.S. Aggregate Bond ETF ( AGG ).

Research and oversight

Investing in individual bonds requires thorough research into the issuer and market trends. This can be time-consuming and requires a strong understanding of fixed-income investing. Fortunately, a wealth of information is available online to aid you in your research.

On the other hand, bond funds alleviate the research burden. Fund managers conduct extensive research and analysis on the issuers of the bonds they hold, ensuring the fund adheres to its investment strategy. They also monitor market conditions and make adjustments to the fund’s holdings as needed.

One potential drawback of bond funds is their expense ratios. These fees, charged by the fund manager, can significantly erode the interest income generated by the underlying bonds. As a result, a modest yield can dwindle to almost nothing.

Income frequency

Individual bonds typically pay interest twice a year, while others pay quarterly or annually, depending on the specific bond.

Bond funds often distribute income monthly, providing a more consistent stream of income for investors. This can be a benefit for investors who rely on their bond holdings to generate regular income.

Minimum investment

Individual bonds can have high minimum investment requirements, sometimes reaching into the thousands of dollars. This can limit accessibility for smaller retail investors.

Bond funds, specifically bond ETFs, benefit from economies of scale, allowing them to negotiate better prices on bond purchases. As a result, investors in bond funds often pay lower costs.

Additionally, bond ETFs typically have lower minimum investment amounts, often as low as a few dollars with fractional shares. This accessibility is in stark contrast to individual bonds or bond mutual funds, which usually require a minimum investment of $1,000 or more.

Liquidity

Selling individual bonds before maturity can be challenging and may result in a loss if interest rates have risen. The bond market is generally less liquid than the stock market, meaning it may take time to find a buyer for your bond at a fair price.

In contrast, bond funds offer the same level of liquidity as stocks, allowing investors to buy and sell shares on any trading day. This flexibility is a significant advantage over individual bonds, which can be more difficult to trade.

Interest rate impact

Both individual bonds and bond funds are affected by interest rate changes. When interest rates rise, the value of existing bonds generally falls. This is because new bonds will be issued with higher coupon rates, making older bonds with lower coupon rates less attractive to investors.

The impact of interest rates on bond funds can be mitigated by diversification. Since bond funds hold a variety of bonds with different maturities, the price changes of individual bonds within the fund can offset each other. This helps to reduce the overall volatility of the fund.

Bonds vs. bond funds: Which should you choose?

Individual bonds may be suitable for investors with a long-term investment horizon, a higher risk tolerance and the desire to actively manage their investments. Bond funds are generally more appropriate for investors seeking diversification, professional management and easier liquidity.

However, the decision between individual bonds and bond funds depends on several factors, including your investment goals, risk tolerance and time horizon.

Bottom line

Both bonds and bond funds offer income potential and can be valuable components of a diversified investment portfolio. Individual bonds offer greater control and potentially higher returns, but they also require more time and effort to manage. However, investors should be mindful of potential drawbacks associated with bond funds, such as high expense ratios. These fees can impact your returns, especially during periods of low interest rates.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.