Which is Better, Bonds or Bond Funds?
For investors who are trying to decide between an investment in individual bonds or bond funds, there are several important considerations.
Individual Bonds: A Higher Probability That You Receive Your Principal Back
One allure of fixed income investing is that in the case of most individual bonds, investors can be assured that they will receive their principal back upon the bond’s maturity. While only bonds backed by the U.S. government - U.S. Treasuries and other bonds backed by the U.S. government, such as savings bonds - even higher-risk market segments feature low historical rates of default (failure to make interest or principal payments) among individual securities. This is particularly true among issues with the highest credit ratings.
Your Principal Can Decline Even in the Safest Bond Funds
Since most bonds mature at their full value, does this mean that investors can also invest in a bond mutual fund and expect to receive all of their principal back?
The answer to this question is a simple “no,” which unfortunately can take some investors by surprise. Like stock mutual funds, bond funds invest in a portfolio of numerous individual securities. Each night, the fund companies assess the value of the securities in their funds and calculate their net asset values, or NAVs. Since each of their individual bond investments can be traded on a daily basis just like a stock, their prices can fluctuate based on market forces. As a result, the prices of bond funds will move up and down along with the value of the securities they hold in their portfolios.
Consequently, an ill-timed purchase can mean that an investor will have to sell the fund at a lower share price than they originally paid since - with the exception of target maturity funds - the vast majority of funds don't mature at par on a specific date like an individual bond. This means that even though a fund may be invested in securities that mature at their original value, the fund itself does not.
The risk, and magnitude, of principal fluctuations depends on the type of fund you own. Some funds only invest in highly-rated, short-term bonds, and in these cases the share price may prove relatively stable over time. Other funds, particularly those that take a more aggressive approach and/or invest in higher-risk securities such as high-yield bonds, can experience substantial share price fluctuations. In 2008, for example, the fallout from the financial crisis caused many high-yield bonds portfolios to lose between 30-40% of their value. Funds that invest in emerging market debt are also among the most volatile options within fixed income, meaning that the odds of short-term losses are elevated.
The Benefits of Bond Funds
On the plus side, funds offer greater diversification than most investors can achieve through individual bonds. Bond funds are also professionally managed, which relieves the individual investors from having to make decisions on their own. Finally, funds are typically easier to purchase and manage than individual bonds.
The Bottom Line
If principal stability is your primary concern, be sure that the investment you choose corresponds with your objective. Even though bond funds have their advantages, funds - even those that invests in lower-risk market segments - may not be appropriate for those who need to have a specific amount of cash available on a specific date.