Bonds vs Bond Funds

Differences Between Bond and Bond Mutual Fund Investing

Should you invest in bonds or bond mutual funds?. Getty Images

Should you invest in bonds or are bond mutual funds better? Is there a best time to invest in one over the other? Here are the basics you need to know to answer these questions...

Definition of a Bond and How Bonds Work

Bonds are debt obligations issued by entities, such as corporations or governments. When you buy an individual bond, you are essentially lending your money to the entity for a stated period of time.

In exchange for your loan, the entity will pay you interest until the end of the period (the maturity date) when you will receive the original investment or loan amount (the principal).

Types of bonds are classified by the entity issuing them. Such entities include corporations, publicly-owned utilities, and state, local and federal governments.

Bonds are typically held by the bond investor until maturity. The investor receives interest (fixed income) for a specified period of time, such as 3 months, 1 year, 5 years, 10 years or 20 years or more. The price of the bond may fluctuate while the investor holds the bond but the investor can receive 100% of his or her initial investment (the principal) at the time of maturity.

Therefore there is no "loss" of principal as long as the investor holds the bond until maturity (and assuming the issuing entity does not default because of extreme circumstances, such as bankruptcy).

An example of a bond would work something like this: The issuing entity, let's say a corporation such as Ford Motor Company, is offering bonds that pay 7.00% interest for 30 years.

The bond investor decides she wants to buy a $10,000 bond. She sends the $10,000 to Ford and gets a bond certificate in return.

The bond investor gets 7% per year ($700), usually split into two 6-month payments. After earning 7% per year for 30 years, the investor gets her $10,000 back.

Definition of Bond Funds and How Bond Funds Work

Bond mutual funds are mutual funds that invest in bonds. Like other mutual funds, bond mutual funds are like baskets that hold dozens or hundreds of individual securities (in this case, bonds). A bond fund manager or team of managers will research the fixed income markets for the best bonds based upon the overall objective of the bond mutual fund. The manager(s) will then purchase and sell bonds based upon economic and market activity. Managers also have to sell funds to meet redemptions (withdrawals) of investors. For this reason, bond fund managers rarely hold bonds until maturity.

As I said previously, an individual bond will not lose value as long as the bond issuer does not default (due to bankruptcy, for example) and the bond investor holds the bond until maturity. However a bond mutual fund can gain or lose value, expressed as Net Asset Value - NAV, because the fund manager(s) often sell the underlying bonds in the fund prior to maturity.

Therefore, bond funds can lose value.

This is possibly the most important difference for investors to note with bonds vs bond mutual funds.

Here's why: Imagine if you were considering buying an individual bond (not a mutual fund). If today’s bonds are paying higher interest rates than yesterday’s bonds, you would naturally want to buy today’s higher interest-paying bonds so you can receive higher returns (higher yield). However, you might consider paying for the lower interest-paying bonds of yesterday if the issuer was willing to give you a discount (lower price) to purchase the bond. As you might guess, when prevailing interest rates are rising the prices of older bonds will fall because investors will demand discounts for the older (and lower) interest payments.

For this reason bond prices move in opposite direction of interest rates and bond fund prices are sensitive to interest rates. Bond fund managers are constantly buying and selling the underlying bonds held in the fund so the change in bond prices will change the NAV of the fund.

In summary, a bond mutual fund can lose value if the bond manager sells a significant amount of bonds in a rising interest rate environment because investors in the open market will demand a discount (pay a lower price) on the older bonds that pay lower interest rates.

Which is Best for Investing - Bonds or Bond Funds?

In general, investors who are not comfortable seeing fluctuations in account value may prefer bonds over bond mutual funds. Although most bond funds do not see significant or frequent declines in value, a conservative investor may not be comfortable seeing several years of stable gains in their bond fund, followed by one year with a loss.

However, the average investor does not have the time, interest or resources to research individual bonds to determine the suitability for their investment objectives. With so many different types of bonds, making a decision may seem overwhelming and mistakes can be made in haste.

While there are also many types of bond funds to choose from, an investor can buy a diversified mix of bonds with a low-cost index fund, such as Vanguard Total Bond Market Index (VBMFX) and be assured average long-term returns and yields with relatively low volatility.

Bond Laddering: When Investing in Bonds and Bond Mutual Funds Makes Sense

'Bond Laddering' is a fixed income investment strategy where the investor buys individual bond securities of various maturities. Similar to CD laddering a primary goal of the investor is to reduce interest rate risk and to increase liquidity.

The best time to use bond laddering is when interest rates are low and beginning to rise. When interest rates are rising, mutual fund prices are generally falling. Therefore and investor can begin gradually buying bonds as rates climb higher to "lock in" yields and minimize the price risk of bond mutual funds.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.