If you are looking to add bond exposure to your portfolio, there are a few questions you have to answer first: what kind of bonds are you looking to add, what duration are you targeting, and will you be purchasing individual bonds or a bundle of bonds through bond mutual fund or ETFs? For the purpose of this article, we are assuming you decided to add taxable corporate bonds to your portfolio. Now your question is if you will be buying individual bond issues or purchasing a basket of bonds through an open ended mutual fund, and close ended mutual fund, or an ETF. Although we only discuss individual bonds and bond mutual funds, the information is also applicable to bond ETFs with the added benefit of lower management fees.
Differences in characteristics
While there are differences between buying a stock and buying a stock based mutual fund, these two investments are fundamentally similar. On the other hand, bonds and bond funds are two radically different investments. Unlike stocks and mutual funds, individual bonds have a definite maturity date. Unless there is a default, you get back 100% of your principal at maturity date, and you receive a predictable income for the period you owned the bond. Bond funds on the other hand act more like stock funds or dividend paying equities: the price of shares rise and fall as there is no fixed principal amount. Also, there is no maturity date as the fund will always roll over into newer bonds as older ones mature. Another difference is that you cannot add or subtract from your holdings if you own individual bonds. You can sell bonds prior to maturity, but you cannot add money (not even the interest they earn) other than purchasing separate bonds.
Advantages of mutual funds
There are many factors that favor mutual funds as the better way to add bonds to your portfolio. Mutual funds offer a good way to diversify bond holdings without having to invest $100,000 or more in individual bonds (there is a $5,000 minimum per bond not counting the discount). The management fees for the mutual fund also pay for professional management. Professional managers save investors from having to investigate price, creditworthiness, maturity, coupon rate and other factors that are important to bond investing. Mutual funds offer more frequent dividends than individual bonds (monthly as opposed to semi-annually). Mutual funds are highly liquid: adding funds, reinvesting interest and cashing out a portion of your portfolio are much easier with mutual funds. The whole process of purchasing mutual funds is much easier than buying bonds.
Perhaps the biggest advantage for those looking for capital appreciation is the ability to easily reinvest the income your investment pays out. In the long run, ‘interest on interest’ accounts for the bulk of total return on a bond mutual fund. While it is possible to reinvest the income from individual bonds, you will have to save up enough to meet the $5,000 minimum, and then you will have to find a new bond to invest in. With mutual funds, if you choose to reinvest the distributions, you easily capture the power of compounding.
Advantages of individual bonds
Individual bonds have the advantage of having a definitive maturity date, predictable income streams, and predictable tax consequences. Depending on your goals and needs, these advantages may outweigh the advantages of mutual funds.
The biggest advantage for individual bonds over mutual funds is that there is no interest rate risk for bonds held to maturity. When interest rates rise, bond prices drop and investors can lose money. This only affects you if you sell bonds prior to maturity, though. Interest rate risk tends to decline as a bond nears maturity and go away completely at maturity as you are guaranteed to get your principle back (barring a default). Mutual funds may hold bonds to maturity, but the newer bonds in the fund will still bear the risk, so you could lose money when you eventually do sell your bond fund. In a risky rate environment, investors may want to look to individual bonds. If you buy individual bonds, even at low interest rates, you will get your initial investment back if the company stays liquid, with a bond fund that is not always true.
You may find this surprising, but in most instances, investing in bond mutual funds is cheaper than buying individual bonds. Bond market professionals tend to get much better pricing when buying and selling bonds. Individual investors tend to pay anywhere from half a percent to five percent more than a professional to buy bonds. This is particularly true for bond purchases under $50,000. There is a markup between the dealer’s purchase price and its subsequent sales price to a customer, and the more the volume, the lower the markup. Mutual funds will have a much higher volume than any individual investor.
That is not to say the mutual funds will not cost you. Funds carry an annual expense ratio which includes management and other fees. Many have a sales charge or transaction fee at time of purchase. As always be sure to understand all of the expenses involved in whatever investments you make.
For the vast majority of investors looking to invest in corporate bonds, mutual funds make more sense than investing in individual bonds. Mutual funds provide better diversification, more efficient management of cash flows, better liquidity and lower costs. Pick a low-cost bond mutual fund if you are simply looking to add bonds to your portfolio.
There are only two reasons to pick individual bonds over mutual funds. If you want your principle returned to you at a certain point in the future and want a better return than a money market fund can provide, a single bond issue may make sense. In risky interest rate environment like we have today, individual bonds can add safety and stability that bond funds cannot. If you are just looking to mimic the advantages of a bond mutual fund by laddering individual bonds, you will need a lot of money and invest a good amount of time just to replicate what you can get by simply investing in a mutual fund.