Bonds vs. Bond Funds

Bond. James Bond. The spy thriller movies are some of my all-time favorites, especially “Goldfinger“. He was connoisseur of fine wines, fine women, fine sports cars, and may have been good with investing. After all, his favorite game was baccarat, may have known that baccarat has some of the best odds at the casino.

With the fixed income part of your portfolio, you have three options to choose from: individual bonds, bond funds, and ETFs. Unknown to most people, holding actual bonds is not the same as owning bond funds. Once you understand the differences, you can determine which is best for you. For the sake of discussion in this article: bond ETFs are the same as owning bond funds. Let’s discuss the differences between bonds compared to bond funds.

Return of Principal

Yes, it’s true, both will give off income, yet if the bond market has a major decrease in price (which means yield rises), bond funds can lose a decent amount of principal. Bonds, if owned directly, you know will end at par value. So while they may change in value during the holding period, the principal is returned at the maturity date. The axiom of you only lose money when you sell definitely holds true to bonds. You know if a bond returns 3.5%, and you hold till term, your return is exactly 3.5% when it matures. Assuming a default has not occurred, you get 100% of your principal.

Maturity Date

Bond funds do not have a fixed rate of maturity. They are comprised of many bonds that are added or removed during the time you own the fund. In 2008, during the financial crisis, the bond market took a major nosedive.  Most bond funds took a hit and experienced a substantial decrease in their NAV price. A Motley Fool article that discusses this in detail. A TIPS ETF (iShares Barclays TIPS), what many would consider secure when owning the individual bonds, lost 10%. Fortunately, most bonds funds made a quick come back.

Income

With a bond fund income can vary, but it typically pays out monthly.  This is because the underlying bond maturity date owned by the fund will vary during ownership. Owning individual bonds, payouts amounts are known, and the dates the payouts occur. By buying specific bonds, you can determine when payouts will occur.

Diversification

When owning a bond fund, you don’t need a lot invested to be properly diversified. When owning an individual bond you have default risk.  When you have only have $10,000 to invest, own only two bonds, and one defaults, you stand to lose 50% of your investment. Many individual bonds have a somewhat high dollar amount to invest in one bond. Ginnie Mae bonds, for example are usually sold in lots of $25,000. To properly diversify with Ginnie Mae’s, this means you should have at least $200,000 – $300,000 to invest. A beginning investor usually does not have that amount to invest, and a bond fund is usually a better choice.

Bond mutual funds have a SEC legal requirement to be a specific class of fund; they must invest at least 80% in bonds. This leaves open the issue of the remaining 20% that can be invested in other types of bonds or even stocks! This means while you wanted to invest in only short term (1 – 3 years) US Treasuries, the fund manager could be investing in riskier assets. All the more reason to read and review the prospectus before investing.

Liquidity

Some bonds are more liquid than others. Muni bonds are often very illiquid. They don’t have a big market compared to the very liquid US treasuries. Meaning if you need to sell a bond before maturity, it’s somewhat harder to find a buyer. The bid-ask price spread could mean you take a decent haircut on any potential profit. During periods of market or issuer-specific stress, the lack of liquidity may result in price volatility. In some cases liquidity can disappear altogether for indefinite periods. On the other hand, if you own a bond fund you can sell at any time.

Fees

Individual bonds are often bought through a broker.  When buying from a broker you not only have transactional costs, but you also run the risk of not getting the best price.  It’s typical of brokers to sell you a bond available in their their local inventory first than finding the best price on the open market.  Though these fees are a one-time deal they can eat into your profit.  With bond funds on the other hand, even if no-load, you have annual fees. Bond mutual funds are managed by professional investors (either active or indexed based), which can be an advantage if you are a novice in managing individual bonds. Specific sectors of the bond market it make sense to use an active manager. Emerging markets bonds is one such example.

Summary

Bond or a bond fund depends upon your specific circumstances. If you have less than $100,000 to invest, in most cases it’s best to own index based mutual funds or ETFs. They offer the best way to diversify, get the proper asset allocation, and are low in fees. With some bonds, like US I Savings Bonds, you must purchase individually and cannot purchase through a mutual fund. No secondary market exists for them, and, therefore, they cannot be owned by mutual funds. With muni bonds, you are best to own bond funds since they are typically illiquid and have a higher default risk than other government bonds. Bond funds, on the other hand, are subject to interest rate hikes and can be more volatile than owning individual bonds.

Comments

  1. Phil Gorian says

    Well written article on bond basics. Bond mutual funds have done well in this environment of falling interest rated over the last two – three decades. As long as interest rates remain low, bond funds should be ok. If things were to change and rates were to begin a longer term increase, bond funds are going to be a difficult investment to be in. Bond fund income will increase with higher rates, but the loss in principal will most likely be substantial. It will take a long time before the higher interest rate income will offset the loss of principle. In my opinion, if your going to be in bonds, good quality individual issues are the safest bet since they mature at face value plus interest.

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