Bonds or Bond Funds?
Many fixed income investors struggle to decide whether to invest in individual bonds or to purchase bond funds. There are thousands of options today, and when building a portfolio, it’s important to understand the implications of both.
An individual bond is a loan to another entity, be it a business, government, or other. Most bonds will pay investors interest every six months, and then return the principal amount when the bond matures. This can provide a stable way to invest for specific events, since the investor knows exactly when to expect their principal back.
Duration is an important concept for bond investors, and measures the magnitude of change in a bond’s market value given a 1% change in interest rates. Whenever interest rates tick higher, older bonds at lower interest rates are not worth as much. The longer into the future the maturity date, the higher the duration, and the larger the change in a bond’s market value.
Bond funds are quite different. In a bond fund, shareholder money is pooled together and invested in different bonds with different maturities. Since funds hold many different bonds, they tend to be very diversified. This is a huge advantage, but investors sacrifice a set maturity date and duration. As each individual bond in the fund matures, the fund manager re-invests (or “rolls over”) the proceeds into a new bond. Since the bonds have different terms, the fund will never reach maturity because the bonds are being perpetually rolled over.
There are pros and cons to both methods, and investor preference will come down to whether they desire control over maturity date and duration. For example, someone investing for college tuition in two years may prefer individual bonds that mature in two years. On the other hand, someone saving for retirement may not know exactly when they plan to stop working, and prefer a fund. The key is to define your long term goals, and build portfolios accordingly.