What is the Difference Between Bonds and Bond Funds?
Bonds vs Bond Mutual Funds and ETFs
Investors wanting to know the difference between bonds and bond funds can benefit by understanding how they work and which of these fixed income types is best for their needs. Some investors may benefit most from individual bonds; whereas, other investors may gain the most advantages from bond mutual funds or bond ETFs.
Difference Between Bonds and Bond Mutual Funds
The primary difference between bonds and bond funds is that bonds are individual securities and bond funds are a portfolio of multiple bonds. There are other differences between bonds and bond funds that are important for investors to know before buying.
- Bonds Definition: 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.
- Bond funds definition: Bond funds are mutual funds or exchange-trade funds (ETFs) that invest in a portfolio bonds. Put another way, one bond fund can be considered a basket of dozens or hundreds of underlying bonds (holdings) within one bond portfolio. Most bond funds are comprised of a certain type of bond, such as corporate or government, and further defined by time period to maturity, such as short-term (less than 3 years), intermediate-term (3 to 10 years) and long-term (10 years or more).
Differences in Bond Price, NAV, Interest Rates and Risk
Some of the less noticeable differences between bonds and and bond funds are focused on the benefits received by the investor. These differences can be understood by learning more about how bond prices, interest rates, market risk, and net asset value (NAV) work with each fixed income type.
- How individual bonds work: Individual 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 the issuing entity does not default because of extreme circumstances, such as bankruptcy).
- How bond funds work: With bond mutual funds or bond ETFs, the investor can indirectly receive interest paid by the underlying bond securities held in the mutual fund. However, mutual funds are not valued by a price but rather a net asset value (NAV) of the underlying holdings in the portfolio. If bond prices are falling, the bond fund investor can see declines in their principal investment (the NAV of the fund can fall).
Bond funds carry greater market risk (more specifically interest rate risk) than individual bonds because the bond fund investor is fully exposed to the possibility of falling prices. However, the bond investor can choose to hold his or her bond to maturity, receive interest and receive their full principal back at maturity, assuming the issuing entity does not default. Equal and opposite, the bond fund investor can participate in rising prices, whereas the individual bond investor will not receive more than the principal investment (unless they sell their bond in the open market before maturity at a higher price than they purchased it).
When to Buy Bonds, When to Buy Bond Mutual Funds
As always, most investors should avoid market timing. With that said, an investor can take calculated risks on their fixed income portfolio holdings by watching interest rates. This is because bond prices typically move in the opposite direction as rates. For nearly 40 years, through 2020, interest rates were generally declining, which made for a positive environment for bond mutual funds. This is because the mutual fund investor was able to participate in price increases, as bond yields declined to historic lows.
- When interest rates are expected to rise: an investor may consider adding individual bonds to their portfolio. This will keep the principal stable while they enjoy the interest received. Investors may also consider a bond laddering approach, which will consist of buying bonds with various maturities as interest rates rise.
- When interest rates are expected to decline: bond prices are rising; therefore bond mutual funds and bond ETFs can be a wise choice. Some fixed-income investors also like to combine bond mutual funds with individual bonds within their total portfolio. This acts like a hedge or a diversification strategy to protect against multiple economic outcomes.
A common misconception about bonds and bond funds is that they are "safe" investments. The primary risk with bonds is the potential for the issuing entity's default. Investors can get some help from credit rating agencies, such as Standard & Poor's, by reviewing their ratings (AAA is highest rating, D is the lowest rating) but credit ratings are not guarantees about the issuing entity's financial soundness.
Bond investors should be careful to diversify into different industries and use caution when buying bonds with low credit ratings (junk bonds). Bond funds can also lose principal and can carry more market risk than individual bonds, especially in economic environments where interest rates are rising (and prices are therefore falling).
The Balance does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.