Smart Bond Investing

Bond Funds

 

Bonds versus Bond Funds


Individual bonds and bond funds are two very different animals. Understanding how bond funds and individual bonds differ will help you assess which is the best investment option for you. Here are four factors you should consider:

  1. Return of Principal. Unless there is a default, when an individual bond matures or is called, your principal is returned. That is not true with bond funds. Bond funds have no obligation to return your principal. Except for UITs, they have no maturity date. With a bond fund, the value of your investment fluctuates from day to day. While this is also true of individual bonds trading in the secondary market, if the price of a bond declines below par, you always have the option of holding the bond until it matures and collecting the principal.

  2. Income. With most fixed-rate individual bonds, you know exactly how much interest you'll receive. With bond funds, the interest you receive can fluctuate with changes to the underlying bond portfolio. Another consideration is that many bond funds pay interest monthly opposed to semiannually, as is the case with most individual bonds.

  3. Diversification. With a single purchase, a bond fund provides you with instant diversification at a very low cost. To put together a diversified portfolio of individual bonds, you'll need to purchase several bonds, and that might cost you $50,000 or more. Most mutual funds only require a minimum investment of a few thousand dollars.

  4. Liquidity. Virtually all bond funds can be sold easily at anytime at the current fund value (NAV). The liquidity of individual bonds, on the other hand, can vary considerably depending on the bond. In addition to taking longer to sell, illiquid bonds may also be more expensive to sell.

Comparing Bonds and Bond Funds

Individual Bonds Bond Mutual Funds Closed-End Bond Funds Bond UITs Bond ETFs
Return of Principal Principal returned at maturity or when bond is called Principal at risk Principal at risk Receive principal back as bonds in UIT mature or are called Principal at risk
Maturity Date Set maturity date None None UIT liquidated on set date None
Income Payments Usually fixed and paid semiannually (except zero-coupon bonds) Fluctuating monthly payments Fluctuating monthly or quarterly payments Fixed monthly, quarterly, or semiannual payments Fluctuating monthly payments
Liquidity Trade on secondary market above or below their face value, but some bonds can be hard to sell Bought and sold at net asset value Trade on an exchange with daily fluctuation in the unit price Bought and sold at NAV Trade on an exchange with daily fluctuation in the unit price
Redeemable Redeemable only at maturity or when called By selling shares at prevailing NAV By selling shares at prevailing unit price By selling shares at NAV By selling shares at prevailing unit price
Default Risk Varies by credit quality of bond Limited by diversification Limited by diversification Limited by diversification Limited by diversification
Interest Rate Risk Exists but declines as bonds near maturity Exists and sensitivity to interest rates depends on portfolio of holdings Because some closed-end funds are highly leveraged, they can be very sensitive to interest rate increases Exists and sensitivity to interest rates depends on portfolio of holdings Exists and sensitivity to interest rates depends on portfolio of holdings
Expenses No ongoing expenses; transaction charge built into price for purchases and sales Annual fees; may have front- or back-end sales charge Annual fees and brokerage commissions Annual fees (usually lower than mutual fund fees) and front-end sales charge Annual fees (usually lower than mutual fund fees) and brokerage commissions
Reinvestment No automatic reinvestment option Automatic reinvestment option Automatic reinvestment option Automatic reinvestment option Automatic reinvestment option available for most but not all ETFs
Professionally Managed No management Actively managed (except index funds) Actively managed Passively managed Most are passively managed; some are now actively managed
Diversification Need to purchase multiple bonds to diversify Constantly changing portfolio of bonds Constantly changing portfolio of bonds Fixed portfolio of bonds; less diversified than many bond mutual funds, closed-end funds or ETFs Constantly changing portfolio of bonds

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