Individual Bonds vs Bond Funds or ETFs: What Works Best? 

Navigating the world of investments is complex, partly because of the extensive choices available to investors today. Bonds tend to often cause even more confusion. That's no surprise since most people understand stocks but not necessarily the realm of debt and yields. Fortunately, adding bonds to your portfolio doesn't have to be difficult. In this article, we'll break down your options for buying bonds, including whether bonds vs bonds funds or ETFs might be a better fit for your needs. 

Please note: this article is intended to provide general information only. Always consult your financial planning professional for advice and specific recommendations.

Rising Rates Put the Focus Back on Bonds

With recent hikes in interest rates, bonds and other debt investments have been getting more attention. However, many people aren't as familiar with these types of investments and don't know where to start. A common question is whether it is smarter to buy via funds or individual bonds. 

When you're ready to start building a diversified bond portfolio, think of it as deciding between buying a single property or investing in a real estate fund. Each choice has its benefits and considerations, depending on your goals, ability to tolerate risk, and desire for simplicity or control.

Why Choose Individual Bonds?

You might consider owning individual bonds if you want to tailor your bond portfolio to very specific goals. But if you go this route, you need to be ready and able to spend more time researching specific bond issues. One benefit you do get is predictable income and clear transparency on when your principal will be returned at bond maturity. 

One big challenge to this approach is the time required to research, buy and sell individual bonds. For an individual investor, this can be time-consuming and requires some advanced knowledge of the bond industry. So consider that before choosing to go with individual bonds. Or, partner with a financial advisor who has the expertise to help you invest in individual bonds effectively.

Why Choose a Bond Mutual Fund?

Choosing a bond mutual fund can be an effective strategy for those seeking diversification and professional management. Bond mutual funds pool resources from many investors to invest in a diversified basket of bonds managed by professionals. This approach reduces the risk associated with individual bonds and eliminates the need for investors to manage their bond investments actively. It's an appealing option for those looking for a hands-off approach that can provide steady income and exposure to a variety of bond markets.

Bond mutual funds are nothing new, as funds have been investing in bonds for decades. Today, however, there is a proliferation of funds suited for specific needs. These range from passively managed index funds that simply aim to replicate various benchmarks to actively managed funds that seek to outperform certain markets.

One risk with any bond investment is default. Default is the risk that a bond issuer is unable to make interest payments or pay back the original principal invested due to financial problems. In that case, the bonds may fail to generate the anticipated total return. With funds, diversification helps minimize the default risk and impact on you individually. But you don't get that with individual bonds. So, keep that in mind that if you opt to purchase individual bonds; in that case, you're on your own to research the credit quality of each investment. 

That diversification is a significant strength of mutual funds. If one bond of many defaults, you would be less impacted. Then, actively managed bond funds usually have a team of credit analysts that research credit quality of the issuers and the bonds to minimize risk of default in the first place.

How do Bond Mutual Funds Work?

Bond mutual funds are most commonly structured as open-ended funds. To buy or sell open-ended funds, you'll deal directly with fund companies. These are different from stocks in that they are only priced once a day after market close. So there's no changing prices minute by minute as publicly traded securities. Finally, the price at which the fund trades is the net asset value. There is no premium or discount on its pricing. Instead, you only pay the collective worth of the fund.

Because these open-ended bond funds are not traded publicly, you may be subject to other rules. Some funds have holding period requirements, so you may be charged an additional fee if you sell them before a specific period (commonly 90 days). In that way, these types of bond funds are not suited to shorter-term trading.

Another aspect of these open-ended funds is that they are not transparent. They usually disclose the fund's holdings (the portfolio of bonds or other investments) on a semi-annual basis, although some funds do report monthly. So investors in bond funds like these need to be comfortable with the fact that you don't know exactly what you own at any time.

Some bond funds are structured as closed-end funds. In that case, they trade on an exchange and can be bought and sold like stocks. These closed-end funds do report their current holdings, so you can see an updated list of bonds outstanding in their portfolio. These funds usually hold a large number of bonds, so even if they have a specialized purpose, they are usually quite diversified.

Why Choose a Bond ETF (Exchange-Traded Fund)?

Bond exchange-traded funds, or ETFs, are a newer entrant to the marketplace. While they share similarities to bond mutual funds, they also have some important differences. Most of today's ETF offerings seek to replicate various bond indices, although a growing number of actively managed products are also available.

One bit of good news: ETFs often have lower fees than their mutual fund counterparts, potentially making them often a more attractive choice. 

These bond ETFs operate much like closed-end funds in that they are purchased through a brokerage rather than directly from a fund company. They can be far more convenient since they trade like stocks and reside alongside your equities in a brokerage account. 

When you are ready to sell, ETFs are sold just like stocks. Like stocks, they trade throughout the day, with prices fluctuating constantly. This aspect can occasionally be a problem during extreme market conditions. Shares can also trade at a premium or a discount to the underlying actual value (net asset value) of the fund's holdings.

Bond ETFs do offer significant flexibility since they usually do not have a minimum required holding period. Also, unlike mutual funds, bond ETFs disclose their underlying holdings on a daily basis, so you know exactly what you own.

Other Hidden Downsides of Bond Mutual Funds and ETFs

Some other issues aren't mentioned as often by financial advisors or in the media. One is the potential for higher fees, which can impact overall returns and the second one has to do with uncontrollable risks.

Are You Paying Two Layers of Fees?

Mutual funds always have a management fee, but it's easy to forget because that fee isn't usually listed anywhere as a debit on your statement. Instead, it's deducted internally, so shareholders don't necessarily see it. 

Now, a fee is fine if the service is helpful for you, of course. Here's the problem. If your financial advisor puts you in bond mutual funds, that essentially means you are paying two layers of management fees. While that might be very appropriate for strategic parts of your investments, if your entire portfolio is in funds, it means you are paying two layers of managers. And, there's no getting around the fact that excess fees can erode your returns. 

Managing Risks in Rising Interest Rate Environments

Another potential issue is something the industry faced in 2022. During that year, the Federal Reserve was aggressively raising interest rates to try to fend of inflation. Bond prices are very sensitive to interest rate changes. In rising rate environments, existing bonds drop in value since investors can now get higher rates from new bonds. 

A mutual fund is a mammoth collection of many bonds that cannot be quickly adjusted. Plus, open-end mutual funds and ETFs are forced to buy and sell bonds as customers buy or redeem shares.

In 2022, many bond funds with longer maturity debt dropped dramatically in price, causing investors to face big losses on what is normally considered a "safer" investment. That’s one reason that if you've got a bigger portfolio, you have far more risk management control with individual bonds. Unfortunately, bond mutual funds and ETFs expose investors to this type of risk that you as an investor can't easily control. 

In addition, these funds can expose you to managerial risks, as the fund's performance is closely tied to the decisions of its managers.

Also, unlike individual bonds, bond mutual funds do not have a maturity date, which means investors do not have a guaranteed return of principal. This can make it more difficult to plan for specific financial goals.

FREQUENTLY ASKED QUESTIONS

How do interest rate changes impact my bond portfolio or fund?

Interest rate changes will impact all of your bond holdings, whether held as bond funds or individual bonds. When interest rates rise, the value of existing bonds typically falls, as investors would prefer new bonds that are issued with today's higher interest rates. This makes older bonds less attractive. 

Conversely, if interest rates fall, existing bonds with higher interest rates become more valuable. This inverse relationship affects the market value of bonds in your portfolio or fund, influencing both the capital appreciation and the income generated from these investments.

In regard to an individual bond, these bond price changes will only impact you if you sell prior to the bond maturing. If you hold a bond to maturity, you will not lose or make additional money due to pricing changes.

What is bond duration, and why does it matter?

Duration is another concept you want to become familiar with whether you're buying individual bonds or taking a funds-based approach. Bond duration measures a bond's sensitivity to changes in interest rates. In practical terms, the longer the duration, the more a bond's price will fluctuate with interest rate changes. 

For example, when interest rates change, a 20-year bond will change in price far more than a 5-year bond.

What are the downsides of owning many individual bonds?

Holding many individual bonds can require significantly more time to manage and monitor. For example, you'll want to track bond maturity dates to know when you need to reinvest. Also, it may not be appropriate for money you may need sooner, as you can be subject to losses if you need to sell individual bonds before maturity.

What's the difference between corporate bonds and municipals?

Companies issue corporate bonds to raise capital for growing or operating their businesses. These bonds typically offer higher yields due to a higher risk of repayment compared to government securities. Municipal bonds, or "munis," are issued by states, cities, or other local government entities and often provide tax-free income for investors. The main difference lies in their issuers, risk levels, and tax implications, making corporate bonds generally more suitable for higher risk tolerance investors seeking higher returns, while munis appeal to those looking for safer, tax-advantaged income.

What are bond credit ratings, and how much do they matter?

Bonds are essentially loans, so the creditworthiness of the issuer is important. Fortunately, there are bond rating companies out there that make evaluating creditworthiness far easier for investors.

Credit rating agencies such as Standard & Poor's, Fitch and Moody's assess the financial viability of the issuer and the likelihood of default. They then assign a risk rating to a bond issue. Overall, they are trying to evaluate the likelihood of interest and principal payments being made on time. Ratings can range from high-grade (meaning low risk) to junk (indicating high risk).

These ratings are critical since they can influence the interest rate issuers must pay to access the bond markets and attract investors. Consequently, higher-rated bonds usually pay a lower rate of interest. As you might guess, "junk" bonds must pay high interest rates to help compensate investors for their increased risk.

Summary: What's the difference between owning a portfolio of individual bonds versus bond funds or ETFs?

As you can probably see, individual bonds and bond funds have different pros and cons. Hopefully, this article has helped you determine whether to invest in individual bonds or bond funds/ETFs, but here's a summary for your consideration.

• Bond funds can be an efficient solution if you're not a hands-on investor, or if you don't work closely with a financial team who can help you with a more customized wealth management approach. However, you are subject to higher fees as well as near constant risk in rising interest rate environments. 
• The diversification of funds or ETFs can be a significant benefit for investors with smaller portfolios. Especially if you've got a lower amount allocated to bonds, the number of bonds you may be able to purchase as individual issues may leave you too concentrated. With bond funds, you get instant diversification. Bond funds usually hold hundreds of bonds at once, and those are usually spread over different maturities, geographical regions and sectors. This often makes bond funds an efficient investment choice, as long as you are aware of the risks.
• Bond ETFs can be a good solution for maximum convenience since you can own them in an existing brokerage account. And as with funds, you get exposure to many different bonds with one purchase.
• Of course, you pay for the convenience and professional management of bond mutual funds and ETFs. If you're already paying a wealth manager, that may mean you're paying two sets of managers instead of one. That extra layer of fees can create a drag on your performance.
•  If you have a wealth manager and your portfolio is large, holding individual bonds can allow you to better manage risk. In that case, you and your financial team will have more control in managing duration risk and selecting bonds that are right for your needs.
• During periods of rising interest rates, you will need to be especially careful with bond purchases. Often, sticking with shorter maturities will help minimize loss of value as rates increase.

In summary, there is no one right answer to the question of bonds vs. bond funds or ETFs. One wise approach is to work with a high-quality financial planner to help determine whether individual bonds or a bond fund make the most sense for you.