What is the Difference Between Bonds and Bond Funds?

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Investors wanting to know the difference between bonds and bond mutual funds can benefit by understanding how they work and when it is best to buy bonds vs bond mutual funds. Individual bonds can be beneficial when rates are low and rising, whereas bond mutual funds are typically best when rates are high and falling.

Difference Between Bonds and Bond Mutual Funds

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 are mutual funds that invest in 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).

Difference in Bond Price, Interest Rates and Net Asset Value

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).

This is not the same as how bond mutual funds work. With bond mutual funds, the investor does indirectly participate in the 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 lose some of their principal investment (NAV of the fund can fall).

Therefore bond funds carry greater market risk than bonds because the bond fund investor is fully exposed to the possibility of falling prices, whereas the bond investor can 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 move in the opposite direction as interest rates. For the past 30 years (the 1980's to 2012, when this article was written), interest rates were generally declining, which made for a positive environment for bond mutual funds because the mutual fund investor was able to participate in price increases.

Arguably the "easy money" for bond mutual fund investors ends when interest rates begin the trend upward (and prices begin their trend downward). Therefore, 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 (and thus bond prices are rising) bond mutual funds are a better 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.

Investor Caution With Bonds and Bond Mutual Funds

A common misconception about bonds and bond mutual funds is that they are "safe" investments. Safe is a relative term. 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 complete and clear windows into 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).