It’s all about stocks in investing, right? You may be surprised to learn how “old school” bonds can be an important part of a balanced investment strategy—providing a predictable income stream and stability to investors when added to a portfolio of stocks.
But many investors lack a strong understanding of bonds compared to stocks, especially when it comes to the differences between investing in individual bonds vs. bond funds.
In this article, we’ll explore the differences between the two, including how they work, their pros and cons and how interest rates may affect your investment.
What Are Individual Bonds?
Individual bonds are a debt obligation issued by a corporation, municipality or the federal government. When you purchase a bond, you don’t buy a “share” of a company like when you buy stock.
Instead, you loan money to the bond issuer, and in return, the issuer pays you a fixed amount of interest, known as a coupon payment, over time, until the bond matures.
If you hold the bond to maturity, the issuer will also repay the bond’s face value, known as the par value.
So, it’s all upside and perfectly predictable? Not quite. If the issuer defaults before it can make the interest and principal payments, you may not recoup your investment. For this reason we’ll dig in on why the reliability of the issuing entity is so key to savvy bond investing.
Interest Rates and Returns
A bond’s interest rate is determined by market conditions and the credit risk of the company or government issuing the bond.
Generally, bonds issued by entities with strong credit ratings have lower interest rates because they’re safer investments. Bonds with lower credit ratings have higher interest rates because they pose a bigger risk to investors.
Individual bonds provide a predictable income stream because you know what the total return will be when you purchase it, assuming there is no default event.
Overview of Bond Funds
Unlike individual bonds which only represent a single interest, bond funds contain hundreds or thousands of individual bonds, representing multiple bond types, credit quality and geographies.
Additionally, bond funds trade on exchanges like stock mutual funds with returns that aim to match or outperform a specific benchmark index.
There are three main categories of bond funds—bond mutual funds, bond index funds and bond exchange-traded funds (ETFs.) Bond mutual funds may be actively or passively managed, whereas bond index funds and bond index ETFs track to a specific index, are passively managed and generally have lower costs.
Why did the industry start to bundle bonds together like this? Put simply, for diversification. When purchasing an individual bond, you are absorbing the risk that single bond could under-perform or even default and return zero.
Bond funds don’t have coupon rates or maturity dates because the bonds within the fund mature at different times, offering a more ‘perpetual’ option to invest in a diversified set of bonds.
As with any type of investing, there is never a guarantee of a return, but the basic principles of diversification exist to hedge against any single investment being a net loss.
Just know that despite bonds generally being a less risky asset than equities and that investing in a wide variety of them via a fund diversifies that to increase it’s predictability, there is still no guaranteed return when you invest in a bond fund.
That said, it’s still very attractive as an investor because investing in one allows you to further diversify your portfolio with a single fund, beyond the diversification you may already have splitting between stocks and bonds overall.
Additionally, bond funds have professional bond fund managers who continuously reinvest the proceeds of maturing bonds into the fund, allowing your investment to grow and making bond funds more liquid than individual bonds.
Additional benefits to be aware of: Management fees tend to be low for index box funds, and the overall cost of investing in bond funds is generally lower than investing in individual bonds, due to the nature of how individual bonds are traded.
Comparing Individual Bonds and Bond Funds
Understanding the differences between individual bonds and bond funds is crucial to selecting the investment option that aligns with your risk tolerance, financial goals and investment timeline.
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Diversification
Creating a diversified bond portfolio with individual bonds can be challenging because it requires a significant investment to purchase individual bonds representing a range of industries, governments, credit ratings and geographies.
Bond funds make it easy to diversify with a relatively small investment because you’re purchasing shares of hundreds or thousands of different bonds when you invest in a bond fund.
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Interest Payments and Reinvestment Opportunities
Purchasing individual bonds provides predictable cash flows because you know what your interest and principal payments will be if you hold the bond until it matures.
But reinvesting the proceeds can be tricky. You’ll either need to do it yourself or hire a bond manager to do it for you.
If you opt to invest in a bond fund instead, there’s no guaranteed return. However, because bond funds gather interest payments from hundreds of different bonds, they generally pay out interest monthly.
Since bond funds have dedicated portfolio managers, the interest your investment earns typically gets reinvested automatically, allowing your investment to continually grow.
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Ease of Trading and Liquidity
Investing in individual bonds is more difficult and less liquid than investing in bond fund shares.
Because bonds don’t trade on exchanges, investors must work with a broker to buy and sell individual bonds. The decentralized environment in which bonds operate also results in a lack of price transparency.
In contrast, bond funds trade on exchanges with transparent pricing, making it easy for investors to buy and sell shares any time the exchange is open.
Additionally, bond funds offer more liquidity than individual bonds with interest payments that can be aggregated and paid out monthly, compared to the semi-annual interest payments most individual bonds produce.
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Price Volatility and Cost
You may expect the price of a bond fund to fluctuate since it’s linked to an exchange’s performance, but many people don’t realize that the prices of individual bonds also fluctuate.
Price fluctuations won’t impact you if you hold the bond to maturity, but if you sell an individual bond early, changes in price will matter, and you’ll subject yourself to the same risk you’d assume by investing in a bond fund.
Additionally, it generally costs more for individual investors to invest in bonds than bond funds, but that doesn’t mean you don’t have to pay attention to the expenses associated with investing in a bond fund.
Because bond funds charge ongoing expense ratios, you must be smart about what bond funds you choose to keep your costs down.
Risk Tolerance, Investment Timeline and Rate Environment
Your risk tolerance, investment timeline and the interest rate environment are key factors to consider when deciding whether to invest in bonds or bond funds (as part of a well-balanced portfolio overall).
Bond funds allow investors to build greater diversification into their portfolio with smaller investment amounts and are generally a better bet for investors with a low risk tolerance.
Long-term bonds and bond funds are typically riskier than shorter-term alternatives because you’re making a longer-term bet that the company you’re investing in won’t default.
Additionally, longer-term bond investments are more sensitive to current interest rate changes than shorter-term bond investments, here’s how that works:
When interest rates are rising, the price of the bond fund will fall. However, bond funds offer investors an opportunity to take advantage of increasing rates because as a portion of the hundreds/thousands of bonds in the fund mature, they can be reinvested at the current higher interest rates.
If you purchase an individual bond and then rates start rising, you’re locked in to the original interest rate if you hold the bond to maturity, missing out on potentially higher returns.
A financial advisor can help you work through the complexities of investing in the bond market and provide personalized advice to help you determine your best options in conjunction with the make-up of your portfolio overall.
Final Thoughts
Whether individual bonds or bond funds are better for you depends on many factors, including your financial goals, risk tolerance, investment timeline and more.
At Plancorp, our financial advisors help you make investment decisions in the context of a comprehensive financial plan, including how much money to allocate to fixed income securities like bonds versus what should ideally be within equities.
Working with an advisor allows you to defer the research and vetting process to us and craft an investment strategy based on decades of research, evidence, and best practices we’re confident in. Our goal is to make sure the next time the market fluctuates, you don’t have any second thoughts that your plan is still on track.
When you have a strategy in place, our advisors will continually review and rebalance your portfolio to ensure you maintain the appropriate asset allocation.
If you’re ready to craft an investment strategy to help you achieve your most important financial objectives, check out our free guide on pursuing a better investment experience for more detailed advice.
