Investing in bonds offers a popular alternative to stocks, especially during periods of stock market underperformance. Bonds provide an important source of cash flow and stability for investors’ portfolios, while offering valuable diversification for those primarily invested in equities.
Just as you can invest in individual stocks or ETFs when entering the stock market, you face a similar choice between individual bonds and bond funds when investing in fixed income. This guide compares individual bonds vs. bond funds to help you determine which option suits your portfolio.
What is a Bond?
A bond is essentially an I.O.U. note from a company or government. When you purchase a bond, you’re lending money to the issuer, who agrees to repay you with interest.
Throughout the bond’s life, holders receive interest payments on a monthly, quarterly, semi-annual, or annual basis. The principal loan amount is returned on the bond’s maturity date.
Bonds are typically priced at face value when first issued. However, market prices can fluctuate based on factors like overall demand for bonds (which rises when stocks fall), interest rate changes, or shifts in the financial condition of the issuing entity.
Why Invest in Bonds?
Several compelling reasons drive investors to invest in bonds.
First, bonds are generally far less risky than stocks and other investment types. Treasury bonds from the US government are considered virtually risk-free since the government has never defaulted on its debt payments. Highly rated corporate bonds from established blue chip companies with strong financial health are also considered extremely low risk.
For investors primarily focused on equities, bonds provide crucial portfolio diversification. The bond market typically rises when stocks fall, enabling bond investments to outperform other holdings during equity downturns.
Another significant advantage is bonds’ extremely low volatility compared to stocks. This makes them an important stability anchor during periods of erratic stock market movements.
Bonds also deliver reliable cash flow and fixed income through regular interest payments throughout their life. Unlike stock dividends, which can be suspended without warning, interest payments are guaranteed and remain constant over the bond’s duration.
What is a Bond Fund?
A bond fund is a mutual fund or ETF that invests in bonds rather than stocks or other assets. These funds contain anywhere from dozens to hundreds of different bonds, often featuring varying interest rates and maturity dates.
Bond funds typically target specific market sectors. For instance, a fund might focus on bonds from companies of a certain size or bonds from state and local governments. Some funds blend corporate and government bonds for broader exposure.
Individual Bonds vs. Bond Funds
While bond funds simply hold numerous individual bonds, key differences between individual bonds vs. bond funds can significantly impact which investment suits your needs.
Management
The primary difference lies in investment control. With individual bonds, you maintain complete authority over bond selection and timing of sales. With bond funds, these decisions transfer to a professional fund manager.
Crucially, this means you cannot choose whether to hold bonds to maturity versus selling them earlier. Individual bonds allow you to purchase and receive principal back at maturity. Bond funds more commonly buy and sell bonds rather than holding them indefinitely.
Professional management benefits many investors, but it’s important to recognize the trade-off in control and flexibility.
- If you want control and flexibility with your bond-buying strategy, individual bonds are the way to go.
- If you prefer the simplicity of a passive investment, bond funds are the way to go
Interest Payments
Bond funds offer a major advantage through consistent cash flow. Since they invest in numerous bonds with staggered interest payment dates, you receive income throughout the year. While payments may vary monthly, you’re unlikely to experience extended periods without interest income.
Individual bonds may not provide monthly income. For example, you might own two bonds paying interest in May and June, but receive no income for the remaining year. If consistent cash flow matters, you’ll need to carefully coordinate different bonds’ payment schedules for year-round income.
While you can structure individual bonds for regular payments throughout the year, portfolio management becomes significantly more complex.
- If you want regular interest payments (like dividends), bond funds may be a good fit.
- If you are not concerned with the frequency/schedule of interest payments, individual bonds may be a good fit.
Diversification
Bond investing carries default risk from issuing companies or governments. Your exposure increases dramatically with individual bonds since larger portfolio portions concentrate in just one or few bonds. Bond funds spread your investment across dozens or hundreds of different bonds. If one company defaults, the impact on your overall investment remains minimal.
Bond funds also provide exposure to diverse bond issuers through a single investment. A fund enables you to access both corporate and government bonds simultaneously. While careful individual bond selection can achieve similar diversification, balancing your portfolio across different bond types requires considerably more effort.
- If you want to diversify your bond portfolio, consider a bond fund.
- If you want to invest in specific bonds, consider individual bonds.
Liquidity
Most individual bonds and bond funds trade frequently, so entering or exiting positions typically poses no issues. However, verification remains important, especially for individual bonds. Some bonds have extremely low liquidity, making it difficult to sell your position when needed.
- If liquidity is a concern, consider a higher-volume bond fund.
- If liquidity is not a concern, individual bonds may be a good fit.
Fees
Buying and selling individual bonds requires paying a markup or mark-down similar to a spread.
Bond funds may require transaction fees upon purchase. They also charge annual management fees (expense ratios), and redemption fees may apply when selling your fund investment.
- If you want to minimize fees, consider individual bonds.
- If the benefits discussed above outweigh the cost of investing in bond funds, consider bond funds.
How to Buy Bonds and Bond Funds
Individual bonds can be purchased through any broker offering bond market access. Many popular US stockbrokers, including Schwab, Fidelity, E*TRADE, and TD Ameritrade provide bond trading (Robinhood and Webull do not).
Bond ETFs trade on stock exchanges just like equity ETFs, so any brokerage offering ETF trading enables bond ETF purchases. Bond mutual funds, however, must be purchased directly through the investment firm that organized the fund.
Conclusion: Individual Bonds vs. Bond Funds
Both individual bonds and bond funds offer valuable portfolio advantages, including diversification, stability, and fixed income. However, important differences between individual bonds vs. bond funds can determine which option better serves your investment goals.
Despite the various considerations discussed above, the decision ultimately centers on one key question:
Do you want to actively manage your bond portfolio or delegate it to professionals?
Bond funds provide bond market exposure with minimal effort. While personal research remains important, professional fund managers handle these investments, eliminating the need to research and purchase bonds independently.
If you prefer complete control over your bond portfolio (and want to minimize management fees), individual bonds may be more suitable.
This preference mirrors the stocks vs. funds decision. Most investors favor the simplicity of investing in several mutual funds or ETFs, while some prefer researching and selecting individual stocks.
