Bonds vs. Bond Funds: What's the Difference?

It's more than just the level of risk

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It's helpful to know how bonds and bond funds differ. For some, bonds may be the best choice; others may gain the most advantages from bond mutual funds or bond ETFs.

The main difference between bonds and bond funds is that bond funds are a bundle of multiple bonds, while solo bonds are not. You should know more about bonds and bond funds before buying either to make sure you're getting the one that is right for you.

What's the Difference Between Bonds and Bond Funds?

Bonds Bond Funds
Are individual securities Are portfolios of multiple bonds
No loss of principal if held until maturity If bond prices are falling, the principal investment may decline
Carry low risk as long as issuing entity does not default Carry greater market and interest rate risk
Better choice when interest rates are expected to rise Better choice when interest rates are expected to decline

Bond and Bond Fund Basics

Bonds are issued debts. When you buy a bond, you essentially lend your money to the entity for a stated period of time. In exchange for your loan, the entity will pay you interest until the date it matures. Then, you will receive the original investment or loan amount, also known as 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.

On the other hand, bond funds are mutual funds or exchange-traded funds (ETFs) that are a bundle of bonds. You can think of it this way: a bond fund is like a basket of dozens or hundreds of underlying bonds.

Most bond funds are comprised of a certain type of bond, such as corporate or government. They are further defined by the time it takes them to mature. They could be short-term (less than three years), intermediate-term (three to 10 years), and long-term (10 years or more).

Price, Net Asset Value, and Interest Rates

Bonds and bond funds differ least in how they are related to the benefits you receive. They can be understood by learning more about how bond prices, interest rates, and net asset value (NAV) work with each fixed income type.

Bonds are typically held until they mature. You receive interest (fixed income) for a fixed period of time, such as three months, one year, five years, 10 years, 20 years, or more.

The price of the bond may fluctuate while you hold the bond, but you can receive 100% of your initial investment when it matures. Therefore, there is no "loss" of funds as long as you hold the bond until it matures. Also, this assumes the issuing entity does not default because of extreme circumstances, such as bankruptcy.

With bond funds, you can indirectly receive interest paid by the underlying bond securities held in the mutual fund. However, mutual funds are not valued by a price; rather, they are valued by the NAV of the underlying holdings. If bond prices are falling, you may see declines in your investment. In other words, the NAV of the fund can fall.

Risk Level

Bonds are less risky than bond funds. You can choose to hold your bond until it matures, receive interest, and receive your full principal back, as long as the issuing entity does not default.

Bond funds carry greater market risk than bonds. This means they carry more interest rate risk because they are fully exposed to the possibility of falling prices within their holdings.

Equal and opposite, you can enjoy rising prices with a bond fund. With a bond, you won't receive an increase in value unless you sell your bond in the open market before it matures for a higher price than you bought it.

Warning

The primary risk with bonds is the potential for the issuing entity's default. You can get some help from credit rating agencies, such as Standard & Poor's, by reviewing their ratings. (For S&P, AAA is the highest rating, and D is the lowest rating.) However, credit ratings are not guarantees about the issuing entity's financial soundness.

When to Buy

You should avoid market timing. With that said, you can take calculated risks on your fixed-income holdings by watching the rates. This is because bond prices typically move in the opposite direction as rates.

Since 1980, interest rates have generally declined, which has made for a positive environment for bond mutual funds. This is because the funds could take part in price increases as bond yields declined to historic lows.

When rates are expected to rise, it may be a good idea to add bonds to your holdings. This will keep the principal stable while you enjoy the interest received. You may also consider a bond laddering approach, which will consist of buying bonds with various maturities as rates rise.

When rates are expected to decline, bond prices are rising; therefore, bond mutual funds and bond ETFs can be a wise choice.

Which Is Right for You?

To know whether investing in bonds or bond funds is right for you, consider each one's downsides to find the best fit for your situation.

A bond may be right for you if you're looking to hold it until it matures and don't want to risk the loss of principal.

On the other hand, bond funds might be the right option if you're looking for a group of bonds that you can sell at any time for capital gains (or losses) and if you don't mind the higher risk level. If rates are expected to decline, buying bond funds might be the better option.

A Best-of-Both Worlds Option

While either a bond or a bond fund may fit your situation best, nothing says you have to choose between them.

In fact, many people like to combine bond funds with solo bonds. This acts like a hedge or a diversification strategy to protect against multiple economic outcomes.

No matter what you invest in, you should always diversify into different industries. And be sure to use caution when buying bonds with low credit ratings—also known as junk bonds.

The Bottom Line

Bonds and bond funds are sometimes seen as "safe" investments, but this isn't always true. Please consider your risk tolerance and investment objective before deciding if bonds or bond funds fit in your portfolio.

If you're looking to minimize your risk, each option has its pros and cons. Individual bonds may carry less market risk but may have a higher credit risk. Bond funds can lose principal and carry more market risk than bonds in markets where rates are rising (and bond prices are falling).

But bond funds could be a better choice if you're looking to diversify credit risk or capture interest rate changes.