Individual Bonds Vs. Bond Funds – Which To Use For Your Portfolio
Investing in bonds is a popular alternative to investing in stocks, particularly during times when the stock market is underperforming. They can an important source of cash flow and stability in investors’ portfolios, and they offer diversification for investors who are primarily invested in stocks.
Just like you can invest in individual stocks or ETFs when investing in the stock market, you have a choice between individual bonds and bond funds when investing in bonds. In this guide, we’ll compare individual bonds vs. bond funds and help you decide which is right for your portfolio.
What is a Bond?
A bond is an I.O.U. note from a company or government. When you buy a bond, you are lending the issuer money and they agree to pay you back with interest.
Over the life of a bond, the holder will receive interest payments on a monthly, quarterly, semi-annual, or annual basis. The principal amount of the loan is returned on the bond’s maturity date.
Bonds are typically priced at face value – that is, the value of the loan you’re offering when you buy the bond – when they are first issued on the open market. However, the market price of a bond can rise or fall in response to factors like overall demand for bonds (demand for bonds rises when the stock market falls), changes in interest rates, or changes in the financial situation of the company or government that issued the bond.
Why Invest in Bonds?
There are several reasons to invest in bonds.
The first is that bonds are generally much less risky than stocks and other types of investments. Treasury bonds like those from the US government are considered virtually risk-free since the government has never defaulted on its debt payments. Highly rated corporate bonds from blue chip companies that have been around for decades and are in good financial health are also considered extremely low risk.
If you primarily invest in the stock market, bonds can be a key source of diversification for your portfolio. The bond market tends to rise when the stock market falls, so bond investments can outperform the rest of your portfolio when stocks are losing value.
Another benefit to bonds is that, compared to stocks, they tend to have extremely low volatility. So, they can be an important source of stability in your portfolio during times when the stock market is moving erratically.
Bonds can also offer cash flow and fixed income since interest payments are made regularly over the life of the bond. Unlike stock dividends, which can be suspended at any time without warning, interest payments are guaranteed and don’t change over the life of a bond.
What is a Bond Fund?
A bond fund is a mutual fund or ETF that invests in bonds rather than stocks or other assets. A bond fund can contain anywhere from dozens to hundreds of different bonds, often with varying interest rates and maturity dates.
Bond funds typically target specific sectors of the bond market. For example, a fund may contain bonds from companies of a certain size or bonds from state and local governments. Bond funds can also mix corporate and government bonds.
Individual Bonds vs. Bond Funds
While bond funds simply hold a large number of individual bonds, there are important differences between individual bonds vs. bond funds that can affect which investment is right for you.
The first difference is who is managing your investment. With individual bonds, you have complete control over deciding what bonds to invest in and when to sell them from your portfolio. With a bond fund, these decisions are handed over to a professional fund manager.
Notably, that means that you do not get to decide whether to hold bonds to maturity as opposed to selling them on the bond market. With individual bonds, you can buy the bond and receive back the principal on the maturity date. With bond funds, it is more common for bonds to be bought and sold rather than held indefinitely.
For many investors, having a professional manage your bond investments is a good thing. However, it’s important to recognize that you give up some control and flexibility as a result.
- 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
One major benefit to bond funds is that since they’re invested in a large number of bonds with different interest payment dates, you can receive cash flow throughout the year. Payments may vary from one month to the next, but it’s unlikely that you will go several months without receiving interest income.
When you invest in individual bonds, your interest payment schedule may not provide for income every month. For example, you may have two bonds that pay interest in May and June, but don’t provide income for the rest of the year. If cash flow is important to you, you will need to consider how different bonds’ interest payments are scheduled so that you have interest payments arriving throughout the year.
Of course, you can invest in individual bonds with payments scheduled across the year, but the management of the portfolio may be complicated.
- 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.
Whenever you invest in bonds, you run the risk that the issuing company or government will default. Your potential exposure is much higher when you invest in individual bonds since a greater portion of your portfolio is invested in just one or a few different bonds. When you invest in a bond fund, on the other hand, your portfolio is spread across dozens or hundreds of different bonds. If one company defaults, it will have less of a significant impact on your overall investment.
Investing in a bond fund can also help you get exposure to a wide range of different bond issuers. For example, a fund enables you to invest in corporate and government bonds with a single investment. While you can achieve similar diversification with carefully chosen individual bond investments, it takes much more work to balance your portfolio across different types of bonds.
- If you want to diversify your bond portfolio, consider a bond fund.
- If you want to invest in specific bonds, consider individual bonds.
Many individual bonds and bond funds trade frequently, so you should not have any issues entering or exiting a position. However, it’s important to check, especially when trading individual bonds. Some bonds have very low liquidity, so it may be hard to sell your position when the time comes.
- If liquidity is a concern, consider a higher-volume bond fund.
- If liquidity is not a concern, individual bonds may be a good fit.
When you buy and sell individual bonds, you will have to pay a markup or mark-down similar to a spread.
When you buy a bond fund, you may have to pay a transaction fee. Bond funds also charge an annual management fee, known as an expense ratio, and there may be a redemption fee when you sell your investment in the fund.
- 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
You can buy individual bonds through any broker that offers access to the bond market. Many popular US stockbrokers, including Schwab, Fidelity, E*TRADE, and TD Ameritrade offer bond trading (Robinhood and Webull do not).
Bond ETFs can be bought and sold on stock exchanges just like stock ETFs. So, any brokerage that offers ETF trading allows you to purchase bond ETFs. A bond mutual fund, on the other hand, must be purchased directly through the investment firm that organized the fund.
Conclusion: Individual Bonds vs. Bond Funds
Individual bonds and bond funds both offer advantages for your portfolio, such as diversification, stability, and fixed income. However, there are important differences between individual bonds vs. bond funds that can determine which is the better investment for you.
While we discussed a lot of points worth considering above, it really comes down to one question:
Do you want to actively manage your bond portfolio or leave it to the professionals?
Bond funds allow you to get exposure to bond markets with minimal effort. While you should still do your own research, these funds will be managed by professional fund managers, saving you the effort of having to research and purchase bonds on your own.
If you prefer to have full control over your bond portfolio (and minimize management fees), you may consider buying individual bonds.
The preference could be compared to buying stocks vs. buying funds. Most investors prefer the simplicity of investing in a few mutual funds or ETFs, however some investors like to research and invest in individual stocks.