There is a lot of decision making when it comes to investing, such as asset allocation, asset location, security type, etc. It’s enough to make your head spin. For fixed income investors, one of the biggest decisions comes down to either owning individual bonds or investing in bond funds. Both come with a certain set of pros and cons. Choosing the wrong one could significantly impact a portfolio and change investment outcomes.
Knowing all the pros and cons is vital to making a decision and choosing what works best for your investing goals. Read on to find out more!
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One or Many?
At its core, a bond is basically a debt obligation from a government, agency, corporation or other entity. When you purchase a bond or bond fund, you’re essentially loaning an entity money with the idea that they will pay back these funds with interest. This interest is paid to the holder until the bond’s maturity date, which can be as short as overnight or as long as 50 or 100 years. When the bond matures, you’ll receive the principal/face value or the original amount you invested.
Individual bonds are single securities issued by entities. When you purchase one, you are buying one IOU – a phonetic acronym of the words “I owe you,”. Bond funds, on the other hand, are collections of individual bonds. By purchasing a bond fund, investors can own hundreds—or, in the case of some index funds, thousands—of individual bonds. They can be passive or actively managed and have mandates dictating what kinds of IOUs they can own.
Individual Bonds: Pros & Cons
The hallmark of individual bonds remains their semiannual coupon (interest) payments and maturity date. When an investor buys an individual bond, twice a year, the issuer will send the investor a check for the interest amount. This is where ‘fixed’ income gets its name. When the bond matures, the issuer will send investors the face or par value.
Over the time of holding the bond, the price and value may fluctuate. However, if an investor holds the bond till it matures, they’ll receive 100% of their initial investment back. This can be vital to income planning and reducing the volatility of a portfolio. Secondly, under this scenario, taxes are limited to interest payments and not capital gains, unless the investor purchased the bond on the secondary market at a discount to par.
Speaking of that secondary market, this is where one major con of owning individual bonds comes in. Holding individual bonds to maturity is ideal. However, that can’t always be the case. Because bond prices change based on underlying conditions and interest rates, investors needing to sell before the maturity date could do so at a loss.
Additionally, the lack of diversification could be a problem. It takes a lot of capital to buy a portfolio of individual IOUs to achieve diversification benefits. Buying individual bonds exposes investors to credit risk and default of the single issuer. This is not necessarily a big deal if you’re buying U.S. Treasuries, but it can be in the corporate and high-yield space.
Bond Funds: Pros & Cons
As a basket of individual bonds, bond funds instantly add diversification for a low initial investment. It could be as low as $1 depending on your brokerage. The best part of bond funds is that investors could have access to some illiquid and difficult to access parts of the fixed income market. Investors are not really exposed to default risk either. After all, if one bond defaults in a portfolio of 1,000 bonds, investors won’t even notice.
That diversification of holdings also allows bond funds to pay monthly dividends rather than semiannually. The drawback to those monthly checks is that the rates tend to be variable. This can hinder income planning as investors need to wait to find out what their next month’s check will be.
The diversification of bond funds does come with some cons. Because of their mandates and the fact they don’t mature, bond funds are constantly rolling over and selling their holdings to match their requirements. As interest rates change, this can have a negative effect on a bond fund’s pricing and cause them to lock in losses. This change happens to individual bondholders too. The difference is, if you hold to maturity, the price doesn’t matter as you’ll get your principal back.
This rolling over can hinder on the tax front as well. Bond mutual funds could be subjected to capital gains taxes on their holdings depending on what a manager was doing throughout the year. ETFs help avoid this tax.
Explore all bond funds here and check out all the available options.
Making the Choice
So, which is better? It depends on what you’re looking for and how you plan on using bonds in your portfolio. If you are worried about volatility in a portfolio, then owning individual bonds and holding them to maturity is the way to go. If you’re looking for monthly income and a chance for gains, then bond funds could be the answer.
Truth be told, they may work best in concert with each other. Holding a portfolio of individual U.S. Treasuries for stability as well as a few bond funds covering other asset classes could provide the best of both worlds. The key is to understand the basic differences and how individual IOUs and bond funds work. This is where investors can make a real decision on their usage for their portfolios.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
