Bond Funds vs. Bonds

Once you’ve decided to diversify your portfolio with a fixed income investment, you’ll need to decide whether bond funds or individual bonds may better suit your risk tolerance, goals, income needs, and desire for liquidity. In many cases, a bond fund may be more appropriate as it offers a convenient, liquid, and cost-effective way to invest in the fixed income asset class.

Bond Funds and Individual Bonds: a Quick Comparison

	Bond Funds	Individual Bonds
Management	Professionally managed	Investor managed
Maturity Date	No maturity date as bonds are constantly bought and sold Fund’s prospectus outlines the weighted average maturity of the bonds in the portfolio	Set maturity date (although some bonds may be called prior to maturity).
Income Payments	Fluctuating monthly income distributions	Usually fixed semi-annual income payment, some monthly or quarterly.
Market Risk	Market conditions constantly affect the fund’s value, although diversification provided by the fund manager may reduce the market risk of any one bond issuer. When shares are redeemed, a capital gain or loss may be incurred.	If sold prior to maturity, market price may be higher or lower, leading to a capital gain or loss. If bought and held to maturity investor is not affected by market risk.
Liquidity	Can sell fund shares at any time, at the current market value (or NAV) of fund, less any redemption fees, if applicable	Can sell bond prior to maturity in secondary market at current market price. Some securities are more liquid than others with U.S. Treasuries among the most liquid and small municipal issues being generally less so. During periods of market or issuer-specific stress, the lack of liquidity may result in price volatility. In some cases liquidity can disappear altogether for indefinite periods.
Diversification	Bond funds provide instant diversification because funds invest in many individual securities. Can be achieved with a small investment.	Investor must purchase many bonds from multiple issuers and maturities to achieve diversification, depending on type of bond. May require significant investment to achieve diversification.
Credit Risk	As safe as the underlying securities Provides diversification, which can mitigate credit risk	Higher rated bonds equal lower risk of default Lower rated bonds equal higher risk of default
Cost	Each fund pays total expenses, which usually includes management and other fees May have a sales load	A markup or markdown upon purchase or sale. The markup/markdown is the difference between the dealer's price and the retail price.

Test Yourself

1. You want to lower the volatility of your equity portfolio with fixed income, but you are not sure how to create a diversified fixed income component of the portfolio. Which would be better for you, bond funds or individual bonds?
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2. You want to provide for a steady income stream, but do not want to risk any of your investment principal. Would bond funds or bonds best suit your needs?
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