Bonds vs. bond funds
Investing in bonds vs. bond funds
In order to choose whether to invest in bonds or bond funds, it’s important to understand the key differences between the two, along with the benefits and risks involved.
Different approaches and risks
Bonds are individual fixed income securities with fixed yields and maturity dates. In contrast, bond funds don’t have fixed yields or fixed maturity dates. This is because bond funds invest in a variety of individual bonds, which are collectively designed to provide potential income continuity to the fund. Investors are paid based on the overall income and return of this portfolio of bonds and not by individual bond maturity. Put another way, this means a mutual fund or exchange-traded fund consisting entirely of bonds is, in fact, not a fixed income asset, but rather a portfolio of bonds that trades as an individual security.
With individual bonds, the risk level depends on the bond’s characteristics like the credit worthiness of the issuer. The credit worthiness of public and corporate bond issuers, for example, is rated by major agencies on a scale ranging from AAA (“Highest Quality”) to D (“In default”).
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The risk profile of bond funds is, in contrast, often in a state of flux because fund managers regularly trade positions. It’s essential, however, to familiarize yourself with the fund management strategy and its approaches to risk prior to investing.
What to ask yourself before investing
There are four questions investors might ask when considering whether to invest in bonds or bond funds.
1. Do I want to take control or do I want a professional to manage my bond investments?
A professional fund manager can monitor and rebalance an actively managed bond fund as necessary, regularly realigning the portfolio with its stated goals. For some investors, this active management strategy is an attractive feature of bond funds, but it typically comes at the cost of management and other fees defined by the fund’s expense ratio.
Investors who prefer to conduct their own research and build a portfolio of individual bonds can forgo these management fees, but may be subject to commission or markup/markdown on individual bond purchases.
2. How much do I plan to invest? Do I want to diversify cheaply?
It’s worth noting that different types of individual bonds like Treasury, municipal, and corporate, require varying minimum investments. The cost of entry may be up to several thousand dollars depending on the bond you choose. And to be well diversified you may need to buy a large number of different bonds.
With bond funds, on the other hand, you’ll need to research the fund to determine whether your goals align with the fund’s stated objective and if you are comfortable with the minimum investment levels. If you are, bond funds may offer a more direct and cost-effective path to diversification.
3. What’s my risk appetite?
There are pros and cons associated with investing in different types of bonds. For instance, corporate bonds can pose higher risk than municipal and Treasury bonds. But higher risk bonds may also offer the potential for higher returns.
With bond funds, choose a strategy that reflects how comfortable you are with different levels of risk. Remember, your risk may be at least somewhat offset by the diversification built into a fund portfolio.
4. Do I prefer a regular fixed income stream or am I okay with fluctuating payments?
There’s a trade-off between convenience and risk here.
Individual bonds typically pay investors on an annual or a semi-annual basis. If you prefer more frequent payouts, you may need to structure your portfolio accordingly, typically by purchasing a number of different bonds with staggered interest payment dates.
Bond funds tend to pay out to investors more frequently than individual bonds. Most bond funds pay investors on a monthly basis. This could potentially offer investors a monthly income stream at a lower investment expense. Payment amounts can fluctuate much more with bond funds, however, as the fund managers trade positions.
Understanding these key differences between bonds and bond funds are an important step in determining which may be appropriate for your particular situation.
Let E*TRADE help
If you have any questions about bonds in general or how to get started investing in bonds, please call us at 1-866-420-0007 to talk with an E*TRADE Fixed Income Specialist, or visit E*TRADE’s Fixed Income Solutions Center (logon required).