Bonds vs. Bond Funds: How They Differ and Which One’s Right For You
Bonds and bond funds may sound like slightly different versions of the same thing, but these investment options function very differently. To start, a bond is something you can buy on your own, while investing in a bond fund (also called a bond mutual fund) means pooling your money with other investors. Both can provide regular income, and both have benefits and downsides. Comparing bonds vs. bond funds should help you get clear about whether investing in one or both makes sense as part of your financial strategy.
How Individual Bonds Work
Corporations, governments and certain other kinds of entities issue bonds as a way to raise capital for new projects or to bolster their cash reserves. Buying a bond essentially means you’re giving a loan to whatever entity issued it.
The price you pay the issuer for a bond is called its par value or face value. The bond matures after a specified period of time (usually somewhere between one and 30 years), and at that point, you’ll get back 100 percent of your original investment. In the meantime, the issuing entity will pay you interest (called the bond’s coupon), typically semiannually.
Here’s a rough example of how this works. Say you buy a bond for the face value of $10,000. The bond has a coupon rate of 5 percent and a maturity date in 10 years. You’ll receive $500 in interest each year ($10,000 x .05). As long as you keep the bond for the full 10 years, you’ll also get your $10,000 back when the bond matures.
Bonds can also be sold before they reach maturity. The price that you’ll get for a bond depends on interest rates and market forces at the time of the sale. If interest rates are high, you may have to sell your bond for less than you paid for it. Inversely, if interest rates are low, your bond’s fixed interest rate becomes more attractive to buyers and you may sell it for more than you paid. Your interest payments end when you sell a bond.
The primary risk associated with buying individual bonds is that the issuer will default on its payments. Ratings agencies give each bond a rating that reflects the financial health of the issuer, giving investors useful information about the likelihood of default.
How Bond Funds Work
A bond fund is a type of mutual fund. When you invest in a bond fund, your money is pooled with other investors’ money. A professional fund manager uses the fund to buy and sell bonds and sometimes other securities. Investors own shares of the fund and receive monthly dividends, which they can either take as income or reinvest in the fund.
The fund’s value is affected by market forces. As interest rates rise, dividends fall. Bond fund investors should be comfortable with fluctuating returns since the bond’s value will constantly change. Because a bond fund owns multiple securities, it’s an ongoing investment with no set maturity date. Investors can typically sell their shares back at any time.
Comparing Bonds vs. Bond Funds
Bonds vs. bond funds: Which one makes sense for you? You don’t necessarily have to choose between them; some people have both individual bonds and bond fund shares in their portfolios. These are some of the factors you may want to consider before making any decisions.
Diversification: Both bonds and bond funds can be used to help you diversify your portfolio, but bond funds are typically the better choice if diversification is a top priority.
Risk: Individual bonds are generally a more stable investment than a bond fund. You’ll get regular, predictable income payments as long as you keep the bond and the issuer doesn’t default. Your investment won’t be affected by changing interest rates unless you sell. Bond funds carry a greater risk. How much income you’ll receive from your investment depends on the market.
Management: Professional portfolio management makes bond funds appealing to some people. It seems easier to have someone else choose and manage the investment. But because individual bonds are typically stable, they often require minimal ongoing management. You don’t have to become an expert in the bond market to choose the right one; your financial advisor can help with the initial purchase.
Initial investment: Bonds vary in price but are typically sold in $5,000 increments. Bond funds allow for more flexibility. Shares vary in price but you may be able to buy multiple shares in a diversified fund for the same price you’d pay for a single bond.
Taxes: As with other kinds of investments, buying and selling bonds may have varying tax consequences. These will depend on what kind of investment you make and any changes you make to your portfolio during the life of your investment. As a financial advisor and CPA, I can help you anticipate your tax obligations.
Here’s my advice: Rather than debating the merits of bonds vs. bond funds within your specific financial plan, let’s have a conversation. Your investment decisions don’t happen in a bubble. They affect your larger financial goals, which in turn affect your entire life. At Sachetta Callahan, we want to make sure that all your investments support those goals.
Michael J Callahan, CPA, CFP®, MST, Partner, Director- Wealth Management is a Certified Financial Planner™ practitioner, Certified Public Accountant, and holds a Master’s Degree in Taxation from Bentley University. Mike has been involved in personal financial planning, as well as both business and individual taxation for more than 15 years.