By: Eva Sadej

Blueleaf’s position: a basket of individual bonds is better than bond funds – but requires active management on the part of the individual investor. If you want to use bond funds, go with bond ETFs.

Individual bonds come in many forms: corporate bonds, government bonds, municipal bonds, and zero-coupon bonds, just to name a few. But individual bonds are oftentimes too expensive for the average person, usually sold in denominations of $25,000 or more [1]. Owning just one bond is risky, and in order to diversify by owning many bonds, you must have a significant pool of investment capital to start with. What if you don’t have that much money to invest?

Bond funds reduce risk exposure at low cost. Instead of buying a basket of individual bonds, many people purchase shares in bond funds, which have minimums closer to $2,500. Bond funds give you instant diversification with low minimum investment. Bond funds are significantly more liquid, in that shares of the bond fund continually trade. Bond funds include Bond Mutual Funds, Bond Index Funds, and Bond ETFs. Bond funds usually pay interest monthly, in contrast to individual bonds, which usually pay out twice a year (except zero-coupon bonds). [2] In addition to the lower dollar amount required to get started, many people choose to invest in bond funds instead of individual bonds to reduce their exposure to the risks of default. There is no question that bond funds offer less risk than individual bonds.

BUT:

Bond funds are very different investments than regular bonds and should not be treated just as safer bonds, because many behaviors and characteristics of bond funds are closer to those of equities.

Bond funds, though less risky, are more unpredictable. Even though bond funds are composed entirely of bonds, they lack a key advantage of individual bonds: predictability. The risk/return profile of the bond fund constantly changes as the fund manager purchases new bonds and older bonds reach maturity. Since they are made up of a number of bonds, they are definitely less risky than individual bonds, but interest payments can fluctuate with changes in the underlying portfolio. In the case of an individual bond, however, the risk level decreases the longer you hold the bond. [3]

Bond funds have few promises. Additionally, bond funds neither have a fixed yield nor a contractual obligation to give investors back their principal at some predetermined date. For a regular bond, your principal is returned when there is a default or the bond is called. In a bond fund, however, the day to day price fluctuates and you do not have the option to just hold the bond to maturity and collect a percentage of your principal after bankruptcy proceedings. [4]

Bond funds have high fees. The fees associated with individual bonds are paid up front, in that transaction charges are built into price and there are ongoing costs. Bond mutual funds, however, have annual fees averaging 0.77% (which makes sense, they are actively managed portfolios as opposed to individual bonds) and may have front or back end sales charges from 3-5%. [5] Buying an individual bond should cost you less than $100 in fees total, whereas an investment of $10,000 into a bond mutual funds may cost you $77 a year, which can add up to much more.

If you would like to invest in bond funds, we recommend bond ETFs, which can have lower expense ratios, as low as 0.15-0.20% and behave the same as bond mutual funds. [6] They aren’t actively managed like most traditional bond funds, but they provide more stability and can be a great tool for incorporating bonds into your asset allocation.