The Pros and Cons of Bonds Versus Bond Funds
Each Have Their Own Advantages and Disadvantages
Investing in bonds, including corporate bonds and municipal bonds, is one of the long-established foundations of any well-diversified portfolio. Even in times of low interest rates, bonds provide a bulwark against stock market and real estate crashes while generating a modest amount of interest income.
Academic studies going back over the past century demonstrate that even a small fixed-income portfolio component, grounded in highly rated bonds, can significantly reduce your portfolio's overall volatility without subtracting too much from your overall portfolio return.
While investing in individual bonds is certainly possible, that may not be advisable unless you have at least a six-figure portfolio. For smaller investors, there is an alternative: A bond mutual fund, or bond fund as it is more commonly called.
When most investors discuss mutual funds, they are often talking about professionally managed investment funds that invest in stocks, commonly in the form of an index. Bond funds, in contrast, pool money from investors to purchase bonds, gaining diversification that would otherwise not be possible for the average investor. Some bond funds specialize in corporate bonds, others in municipal bonds, still others in junk bonds. In fact, the odds are if you want to own a specific type of bond, there is a bond fund that will let you do so with as little as a few hundred, or perhaps a few thousand, dollars.
The Benefits of Investing in Bond Funds
There are several advantages to investing in bond funds, including the following:
- Bond funds typically pay higher interest rates than certificates of deposit, money market funds, and bank accounts.
- Ordinarily, it would be impossible for small investors to put together a diversified bond portfolio because bonds must be purchased in much larger denominations than stocks, in denominations such as $1,000, $5,000, $10,000, $25,000 or more depending upon the issuer. It isn't a problem because bond funds trade at smaller share prices, making diversification possible for those with only a few thousand dollars, reducing risk.
- Investors can get the benefit of professional money managers that know their field. It wouldn't be worth the time or effort for the average person to learn the different rules for municipal bonds, for instance, such as the substantial differences between General Obligation Bonds and Revenue Bonds. Owning bond funds makes the point moot because the fund manager is responsible for such day-to-day research.
- Bond funds typically receive better pricing than the small investor can get on the acquired bonds. Unlike the stock market, where the bid and ask are clearly disclosed, you may not know how much of a markup your brokerage firm puts on a bond. The "spread," as it is known, between what the buyer pays and what the seller receives on a specific bond can be huge when purchasing individual issues. Due to their size, scale, and willingness to take large positions, bond funds have much better odds of achieving attractive pricing.
- Investing in bond funds is much, much easier than owning individual bonds outright because you don't have to take care of "laddering" your portfolio (that is, managing the maturity date of different bonds), recording each individual interest check as it comes in or is deposited into your brokerage account, or dealing with special situations such as bonds that are called by the company, meaning that the company forces you to sell the bonds back to them based on the original bond agreement. With bond funds, all of that is taken care of at the managing company. You simply get your regular distributions of profit from the bond holdings and that it.
- Many bond funds pay out interest and gains monthly instead of semi-annually, as is the case with individual bonds. It makes cash flow much less stressful for income-oriented investors who need more frequent deposits for day-to-day bills.
The Drawbacks of Investing in Bond Funds
Like many things in life, there's a bit of sour to go with the sweet when it comes to bond funds. Despite all of the benefits mentioned above, there are some drawbacks to investing exclusively through bond funds rather than acquiring your own individual bonds. These drawbacks include the following:
- Bond funds typically have higher expense ratios, meaning that more of each dollar goes to management fees than a comparable stock mutual fund.
- With an individual bond, risk decreases the longer you hold the security because you get closer to maturity when you receive your principal back from the company or organization to whom you lent it. It is not true with bond funds because the individual holdings are constantly maturing, being bought and sold, etc.
- In the case of aggressive management, bond funds can take on leverage. If you don't pay attention to this, you might be exposed to significant potential capital losses and not even know it. Generally speaking, it is highly inappropriate for average investors to own leveraged bond funds and they should be avoided like the plague if you have any sense of reasonable risk management.
- Monthly income from bond funds fluctuates as the underlying bond assets change. You won't know precisely how much you are going to collect in any given year.
- Some bond funds charge redemption fees if you sell your shares within a certain time period (say, 60 or 90 days).
- Certain bond funds may have sales loads, which are essentially fees and commissions to the fund company or financial institution that sold you the investment.
Investing in a Bond Fund for Your Family's Portfolio
The truth of the matter is that there is no right or wrong answer when it comes to investing in bond funds. Bond funds make sense for those who have less than $100,000 to devote to their fixed income portfolio or for those who simply want the convenience of buying and selling a basket of bonds with a single transaction.