“Should I own bond funds or a portfolio of individual bonds?
This is a question I get from a lot of clients. Bonds play a crucial role when it comes to building a solid investment portfolio. But with various options available, it can be difficult to decide without knowing all the ins and outs. And many worry about the effect that rising interest rates could play.
In my practice, most clients are far better off utilizing bond funds and ETFs, which offer several advantages over individual bonds. There are a few key differences, so here’s what you should know.
What are Bond Funds/ETFs?
Bond funds (or bond mutual funds) and ETFs pool money from numerous investors to invest in a diversified portfolio of bonds. They have a variety of issuers, maturity dates, coupon rates, and credit ratings. These investments are managed by professionals that can offer client income and diversification over the long run. Unlike individual bonds, bond funds offer no guarantee that you’ll recover your principal at a specific time, especially in a rising-rate environment.
The Benefits of Bond Funds and ETFs
A Diversified Approach: With bond funds, it’s much easier to achieve a diversified bond portfolio per dollar invested. Since these bonds spread your investment across various bonds with different qualities and criteria, there’s a reduced risk than that associated with investing in individual bonds, where a single default can significantly impact your returns.
Professional Management: Bond funds are managed by experienced professionals who continuously monitor the market and adjust the fund's holdings to optimize performance, taking the responsibility off you.
Lower Costs: Bond funds offer investors access to institutional pricing, which typically have lower transaction costs and expense ratios, leading to higher net returns over time.
Greater Liquidity: Bond funds are more liquid than individual bonds, making it easier to buy and sell shares when needed. This is a key advantage for those worried about rising interest rates.
Other Things to Consider with Bond Funds/ETFs
There are some downsides to bond funds to think about when making your decision. With these bonds, there are on-going management fees, which can be higher for more actively traded bond funds. Individual bonds typically only have a mission charged at the time of purchase. The net asset value (NAV) will also fluctuate with the market, so as interest rates rise and fall, its NAV will change as well, making it harder to predict where it will be in the future. Capital gain distributors can also be harder to anticipate and plan for from a tax standpoint. Since money is pooled in order to purchase the portfolio's bonds, your cost basis when it comes to taxes won't be as simple as purachings an individual bond at maturity.
What are Individual Bonds?
A portfolio of individual bonds produces reliable income streams for investors. They allow you to target specific maturities to anticipate targeted incomes for specific dates. But the appeal of holding an investment until maturity, they also tend to come with an opportunity cost. Here are some of the draw backs:
Higher Costs: Transaction costs for buying and selling individual bonds can be higher. While those who purchase large quantities of bonds at once will typically receive better pricing, smaller trades pay a larger price. The best pricing for individual bonds is usually $10 million or higher for a single issue.
Limited Diversification: Building a well-diversified bond portfolio with individual bonds requires significant investment. There are several sub-asset classes within a fixed income market, making it challenging and cost-prohibited for most investors.
Time Commitment: With thousands of individual issuers available for purchase, managing a portfolio of individual bonds can be time-consuming. It will require you to monitor each bond's performance and make adjustments as needed all on your own time and resources.
Other Things to Consider with Individual Bonds
Like bond funds, individual bonds have their own advantages depending on what you’re looking to achieve. In addition to being a reliable income stream for major upcoming expenses (college tuition, real estate, etc), they also make your investment more predictable. Unlike bond funds that are susceptible to market fluctuations, you’ll receive the par value of the bond at maturity, barring default. In addition, your cost basis is determined based on the price you pay to purchase the bond and the amortization of any premium or discount, which is helpful for tax-planning purposes.
A Direct Comparison of Individual Bonds & Bond Funds/ETFs
Individual Bonds | Bond Funds/ETFs | |
Management Structure | Managed by Investor | Professional Management (Active or Passive) |
Amount Invested | Large | Small |
Fees & Costs | Commission to buy or sell, but no on-going fees & bid/ask is wider | Lower management fees & sales fees depending on the share class, & bid/ask is narrower |
Income Frequency | Semiannually | Monthly |
Reinvestment | No | Yes, at potentially higher rates |
Predictable Market Value at Maturity | Yes, barring default | No |
Cost Basis | Individual cost basis for each bond | Cost basis is based on the cost paid for the share of the fund |
Diversification | Harder to achieve | Easier to achieve |
Understanding the Impact of Diversification with Bond Funds
To better understand the power of a diversified bond portfolio, here’s an example. Let’s say you’re investing $10,000 in an individual bond issued by Company A. If Company A defaults, it’s likely you could lose a significant portion of your investment.However, if you invest the same amount in a bond fund that holds bonds from 100 different companies, the impact of a single default is significantly reduced, protecting your overall investment.
Bond Funds vs. Individual Bonds: The Key Takeaways
Bond funds and ETFs offer a more efficient and diversified way to invest in bonds, especially for long-term investors. Overall, they tend to offer greater return opportunities, lower transaction costs, and higher liquidity than individual bonds. And with the benefit of having your investment spread across several issuers with differing credit qualities, and maturities, your fund portfolio is effortlessly diversified without making individual investments.
While individual bonds may have their own time and place given specific circumstances, they may not be the most suitable option for everyone.
Let's Discuss Your Bond Investment Strategy
K Wealth Advisors is here to help you make informed decisions about your bond investments. If you want to discuss your financial goals and risk tolerance to determine the best approach for you, give us a call today. We’ll be more than happy to schedule a GoodFit meeting to discuss your goals and options. #KWA
Insightful Planning to Live Your Best Life. #IPtLYBL
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Resource: Vanguard Advisors: Bonds versus bond funds.
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