Bonds Versus Bond Funds
Key Points in Bonds Versus Bond Funds:
- What bonds provide
- Types of bond funds
- Building an income stream
- Spreading out risk
- 4 minute read
What do Bonds Provide?
A well-diversified investment portfolio is one of the cornerstones of a well-crafted financial plan. Not only is it a good idea to have a variety of different types of stocks in your long-term investment accounts, but it is also typically wise to own other types of assets, like bonds.
Bonds can provide:
- Income from their coupon payments.
- Protection from the volatility of the stock market.
- Potentially a hedge against higher inflation in the future.
The Difference Between Individual Bonds and Bond Funds
Let’s say you’re hungry and thinking about what you want to have for dinner. Some people may pull things out of the refrigerator and pantry and follow a recipe to create a meal from scratch.
Other people pull up Door Dash on their phone and have a prepared meal delivered to their front door. In the end, regardless of the method used, both people wound up having something to eat for dinner, so the results were similar, although there were differences in their methods.
Building a portfolio of individual bonds is sort of like cooking from scratch, piecing together ingredients, and following a recipe to create a meal.
Adding a bond fund to your portfolio, on the other hand, is sort of like ordering take-out. The meal is prepared for you by a professional, and you don’t mind paying that professional for their services and the convenience of not having to cook for yourself.
Adding Bond Exposure to Your Portfolio
There are several ways of adding exposure to bonds in your portfolio. You may choose to research a company’s financial health or a municipality and invest directly in that organization’s debt by purchasing individual bonds.
Mutual funds and ETFs have prepackaged groups of bonds for you. Whether you choose to use individual bonds or bond funds can result in a different investing experience, so it is important to understand what you’re getting into from the start.
There are proponents of individual bonds that will argue that it is difficult to know exactly what you own with bond funds. Proponents make a similar argument of individual stocks versus stock funds.
For example, take a look at the bond from a search run on March 5, 2021.
You would know that the coupon rate (the rate of interest paid by the issuer, in this case, Bank of America) is 4.25%. You would also know that the bond will mature on March 15, 2030, at which point, Bank of America would need to pay back the original loan amount to the bondholder.
It’s important to note, the amount paid back at maturity is not necessarily the amount you bought the bond for. This is because individual bonds can be bought and sold on the market for higher or lower prices, depending on various factors. With individual bonds, the bonds will mature at their par value. The par value is the price the bond issuer agrees to pay the bondholder at the maturity date.
Oftentimes you will buy a bond at a different price than its par value. When you pay a higher price than the par value, you buy that bond at a premium. When you pay a lower price than the par value, you buy the bond at a discount.
Whether you pay a premium or a discount can determine your “yield to maturity,” effectively your yield after factoring in your purchase price and the par value. When you buy a bond fund, the yield to maturity is usually stated for you, along with other information, such as the average credit quality, average maturity, and other valuable information.
Individual Bonds, Mutual Funds, or ETFs
One of the benefits of owning individual bonds may be that you better understand what is in your investment account.
On the other hand, it may be more difficult to understand what’s in your investment account if you own bond mutual funds or bond exchange-traded funds. For example, one of the largest bond mutual funds on the market is the Vanguard Total Bond Market Index Fund.
You can purchase shares of this mutual fund just like any other mutual fund available (the Admiral share class has a minimum initial investment of $3,000). Vanguard has prepackaged more than 10,000 individual bonds (as of January 31, 2021) into this mutual fund.
It would be impossible for the average investor to know the same information about each of these bonds as they would know in the Bank of America bond example earlier. It’s sort of like when you go to a restaurant and order a meal. You can’t be sure exactly what all of the ingredients were that went into preparing that meal. Did the chef use vegetable oil or olive oil? When you cook at home, you know exactly what you used to create your meal.
Fund managers, such as Vanguard, provide investors with valuable information, such as the average coupon rate of bonds in the fund and the fund issuers’ average credit rating. So, at least you have a good idea of the characteristics of the bonds inside the fund.
Building an Income Stream
Proponents of individual bonds will argue more predictability of future income is another benefit of owning an individual bond. You simply purchase the bond in your investment account.
The bond issuer pays the interest to your account on a pre-determined basis (most bonds pay their interest semi-annually) until the bond reaches its maturity date (known by the investor in the bond ahead of time).
At this point, the investor receives the original loan amount back (again, this amount can be different than what the investor’s investment was if the bond was purchased at a premium or a discount on a secondary market).
When you invest in a bond fund, you essentially give up some control over exactly which bonds you invest in. While the bonds inside the fund have the same characteristics of the bonds in a portfolio of someone who purchases individual bonds (semi-annual interest payments, maturity dates, etc.), the bond fund may choose to pay its interest rates out monthly.
Bond funds will also typically not have a maturity date. Rather, as the bonds inside the fund reach their maturity, the bond fund manager will take the money received from the bond fund and invest it right back into another bond. The investor in the bond fund would continue to receive the interest income the bond fund pays out.
Spread the Risk
Of course, there is risk with any investment, and that is no different when it comes to investing in bonds. If you want to have a diversified portfolio, you will want to own many different bonds. This is where investing in bond funds as opposed to individual bonds can be more convenient.
The Vanguard Total Bond Market Index Fund mentioned earlier in the post is comprised of over 10,000 individual bonds. Vanguard has essentially done the diversifying leg work for you and packaged it neatly in a mutual fund. For their trouble, they charge a fee, called an expense ratio, of 0.05% per year.
If you are not happy with giving up the control of selecting the individual bonds, you’ll need to research and find the bonds to invest in. Much like finding a new recipe and testing it out to see if it’s any good, you’ll need to see what type of bonds fit in your plan.
Typically, you will pay some sort of commission when buying an individual bond, called a “mark up.” This fee goes to the broker and is usually built into the price of the bond you are purchasing, so you’ll want to make sure you understand exactly what the fees are.
Like ordering delivery versus preparing a meal from scratch, in the end, your results may be similar. It’s your choice whether you invest in bonds by purchasing individual bonds or shares of a bond fund. However, bonds can be an integral part of your investment portfolio, potentially providing an income stream, diversification from stock market risk, and more predictable returns.
CFP®, AIF®, EA | Financial Planner
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Investment advisory services offered through Barber Financial Group, Inc., an SEC Registered Investment Adviser.
The views expressed represent the opinion of Barber Financial Group an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Barber Financial Group does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.