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June 23, 2018
When it comes to fixed income investing, there are two options available to investors. You can own individual bonds, or you can purchase shares of a bond fund. Both options have unique advantages and disadvantages that make them suitable under certain conditions.
We’ll begin by summarizing the differences between bond funds and individual bonds, and then we’ll list out the pros and cons of each.
Owners of individual bonds receive a commitment from the issuer to receive predefined interest payments, usually semi-annually, and a return of their principal upon maturity of the bond. As long as the issuer doesn’t default, bond owners can count on this reliable income stream. Knowing exactly how much income you will receive, the corresponding rate of return you are earning, and that you will receive your principal back when agreed, makes individual bonds attractive for their transparency.
Bond funds, on the other hand, are a completely different animal. Purchasing shares of a bond fund is technically still considered fixed income investing, but the nature of these funds poses additional considerations and complicates your investment considerably.
When you purchase a bond fund, you are pooling your money with other investors and allowing a professional money manager to purchase, hold and sell bonds on your behalf. Different bond funds have different investment strategies, but all bond funds share some similar characteristics.
To begin, most bond funds hold a variety of bonds that mature at different times. This allows the bond fund to make periodic payments to its shareholders, distributing the income that the bond portfolio generates. While these distributions are designed to mimic the periodic interest payments of owning individual bonds, they can fluctuate based on the performance of the bond fund.
Another critical aspect to understand about bond funds is that there is no maturity date upon which you can expect to recoup your initial investment. Said differently, there is no assurance of getting back 100% of your principal. When you invest in a bond fund, you are purchasing shares. The price of these shares will fluctuate based on a number of factors. If you decide you want your money back, your only course of action is to sell your shares at whatever the going price is.
Now that you have a basic overview of the difference between owing individual bonds and a bond fund, let’s go through the pros and cons of each.
Another critical aspect to understand about bond funds is that there is no maturity date upon which you can expect to recoup your initial investment. Said differently, there is no assurance of getting back 100% of your principal. When you invest in a bond fund, you are purchasing shares. The price of these shares will fluctuate based on a number of factors. If you decide you want your money back, your only course of action is to sell your shares at whatever the going price is.
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