Why Bond Funds Benefit Investors More than Individual Bonds

Bonds vs. Bond Funds: What’s the Better Investment?

Buying individual bonds can expose investors to unnecessary risks

As fixed-income markets draw investors weary of the turbulent stock market, a common question arises: are bonds or bond funds the better investment? The short answer: While there are advantages and disadvantages to both, well-managed bond funds are usually preferable, and can benefit a portfolio in ways other investments cannot.

The reliable income individual bonds provide appeal to many investors, with set interest payments (generally twice a year) and a date the principal will be paid back. But this predictability still comes with a number of uncertainties:

  • Defaults. There’s always a chance that an issuer will be unable to repay a bondholder’s principal. It’s unlikely when bonds have higher credit ratings, but it’s still a risk that goes up with an individual bond vs. a fund.
  • Callable bonds. If a bond is redeemed by the issuer before it matures, investors receive a predetermined call price that could be less than they paid.
  • Rising interest rates. If investors hold a bond until it matures, they will receive its face value. But if the investor sells before the bond reaches maturity, higher interest rates can negatively impact its market value.

Buying individual bonds is rife with complexity and the average investor lacks the time, interest, or resources to research the many different types to determine which ones best suit their investment objectives. Without professional support, interested parties must research and monitor the issuer’s financial stability; determine if a bond price is reasonable; build a portfolio that’s based on income, risk tolerance, and general diversification; and best determine how to reinvest the proceeds.

It’s not unreasonable to assert that investing in a variety of individual bonds requires a commitment of at least $500,000 – depending upon the types of bonds chosen and their credit risks – to ensure a comfortable amount of diversification.

Bond funds are a diversified option during unsure economic times

Bond-focused mutual funds have long been favored by investors seeking steady cash flow at low risk or a safe haven during tough economic times. Like stock mutual funds, bond funds allow investors to pool their money for skilled professionals to invest in accordance with the fund’s stated investment goals.

While bond funds can’t reach the upside potential of equities investments, their weak or negative correlation with growth-oriented mutual funds that focus on stocks or real estate makes them a valuable counterweight in an investment portfolio.

They do have their shortcomings. Since they don’t offer a fixed maturity, your principal and your income aren’t as certain as they would be with individual bonds. While most bond funds don’t see significant or frequent declines in value, an investor’s interest payments and the fund’s share price will fluctuate since fund managers are constantly buying and selling bonds in their portfolios. Bond prices generally move in the opposite direction of interest rates, which aren’t expected to rise this year.

But at the end of the day, bond fund benefits outweigh the small amount of risk:

  • Lower costs. By buying in bulk, fund managers generally receive better prices than individual investors.
  • Diversification. Since bond funds invest in many different debt securities, it’s an easy way to achieve diversification, even with a relatively small investment. Bond funds typically hold hundreds and even thousands of issuers, ensuring reasonable diversification to mitigate risk. The array of different maturities, yields, and durations of bonds within the fund also helps diversify an investor’s cash flow stream.
  • Expertise. Fund managers employ dedicated research departments to help them determine the best opportunities – a particular advantage when accessing unfamiliar or complex parts of the market. An alternate option are passively managed index bond funds which track indices of different categories of bonds. These involve lower fees but, on average, could be more sensitive to changes in interest rates than some actively managed funds.

 

Bond funds mitigate risk more easily

Put simply, bond funds give investors globally diversified portfolios at lower costs and with less effort than attempting to create a properly diversified portfolio of individual bonds. Those looking to access high-yield and international bonds – or other areas of greater risk but potentially greater reward – can especially benefit from the professional management and diversification many funds provide.

In addition, bond funds enable investors to reinvest bond payouts automatically, which isn’t possible with individual bonds. Their shares are also much easier to sell.

And if interest rates rise, the diversification of bond funds helps alleviate the sting of the price decline bonds experience. Since individual holdings within the fund are constantly maturing, bond fund managers can continuously reinvest the proceeds into the new market interest rates. Individual bonds miss the opportunity to invest at higher future rates before they reach their maturity date.

Contrary to what many investors assume, investing in individual bonds doesn’t shelter you from risk, and they require due diligence and resources to diversify properly. Bond funds enable investors to easily diversify and reap the unique benefits of debt securities by investing in a wide swath of bonds efficiently and economically.

Lindberg & Ripple is an independent investment and insurance advisory firm providing sophisticated Wealth Management, experienced Investment Consulting, and innovative Insurance Solutions for wealthy families, successful executives and business executives. Contact us to learn how we can help your family or business achieve your financial objectives, while minimizing hassle, expense, and taxes.