If you are looking to invest in lower-risk assets, bonds and bond funds are good options for you. The first thing to decide, though, is which of the two would be best for you. The answer to that question lies in understanding how each option works.
First, Let’s consider the meaning of each option, and later we will consider their differences.
Definition of a Bond
A bond is an investment in a corporation that yields fixed interest annually. It has two points of view. On one side we have the borrower, who is the company issuing the bond. On the other side, we have the investor who lends money to the company.
We are interested in the investor’s point of view.
The investor can be an individual person or a corporate body. Upon investment, the borrowing company issues a bond certificate to the investor or the lender.
A bond has a fixed maturity period. It can mature within a short period such as 3 months or over a long period of time such as 30 years. The interest rate remains fixed. For example, a bond issued at 7% interest rate per year, will receive interest at that rate until it matures.
When the bond matures, the principal will be paid. For example, assume that a bond with a principal amount of $30,000 at an interest rate of 7% was issued in 2020 with a maturity period of 10 years.
The principal amount of $30,000 will be paid after 10 years. The 7% interest will be paid every year for 10 years based on the principal amount.
Definition of Bond Funds
A bond fund is a pooled investment just like a mutual fund. It is an investment in bonds made by many investors together. Unlike a mutual fund, a bond fund is invested specifically in bonds.
Instead of investing in only one company, a bond fund is usually invested in hundreds of companies. This is possible because the number of investors in the fund is high.
A bond fund is organized into a company and the investors are members of that company. A fund manager is appointed to oversee the investment of the company.
Unlike individual bonds, bond funds can be sold before the maturity period. This is necessary because bond funds seek to make short-term gains through trading in the bond market.
Investors are paid interest every month. At the end of the year, dividends are paid based on capital gains.
Capital Gains and Losses
Bond funds can lose or gain value but individual bonds cannot. This is because bond funds are sold before maturity and individual bonds are not.
Let’s say a company issues 7% bonds in one year and 8% bonds in another year. Assume the price per bond is the same. If the two bonds are trading in the market, which one would you buy? Definitely, the 8% bond because it will give you higher returns.
However, if an investor sold you the 7% bond at a discount (lower price), then you would consider buying it. This means that if the current interest rate is higher than the older one, older bonds can only sell at a lower price.
Investors in older bonds will sell them at a loss. This loss is called a capital loss.
The relationship between interest rate and the price of bonds is negative.
On the other hand, if current interest rates were to fall, older bonds whose interest rates are still high would look attractive and sell at a higher price. The investors who sell older bonds would have capital gains.
This kind of capital gain and capital loss is not something you find in individual bonds held to maturity. At maturity, they are redeemed, not sold.
If you are risk-averse you are likely to go for individual bonds instead of bond funds. Individual bonds have a lower risk because there are no uncertainties. The interest rate is known and fixed. The maturity period is known and fixed and so is the amount to be paid at maturity.
However, an investor who invests individual bonds in just one company faces a higher risk. The company could default payment due to bankruptcy or due to other reasons. In such a case the investor would lose everything.
Unless the investment is made on government bonds which are usually risk-free. Unlike companies, governments never go into bankruptcy.
Risk-seekers are likely to go for bond funds. Bond funds are risky because they have no fixed maturity period and no fixed interest rate. These bonds can be sold and bought at any time.
Traders in bond funds are speculators. They seek short-term gains by buying bonds at lower prices and selling them at higher prices.
Frequent trading in the bond market exposes the investors to price fluctuations. You can buy bonds at a higher price only for the price to fall shortly after purchasing them. The fund’s managers must keep monitoring the market trends in order to spot opportunities and make wise investment decisions.
The high risk in bond funds can be mitigated through proper diversification. To do this, the bond funds are invested in very many companies. If one company fails to honor its debt, the other companies will honor their obligations.
This minimizes the loss that investors would have to suffer if they relied on one company.
Bond funds have recurring costs which may reduce investors’ return. Frequent buying and selling mean recurring transaction costs.
Bond funds are managed by professionals who are highly qualified finance managers. Since they work as full-time employees, they have to be paid salaries. Apart from the salaries paid to them, other expenses are incurred in running the bond funds company.
These expenses will have to be deducted from the income obtained by the company. As a result, investors will get lower returns.
On the other hand, an individual bond incurs no such cost.
It is easier to invest in bond funds even with less money than to invest in individual bonds. In bond funds, money is contributed by many investors making it less burdening. In individual bonds, one investor bears the whole investment burden
In order to have a well-diversified portfolio, investors need to invest in tens or hundreds of companies. Doing this as an individual investor is cost-prohibitive. It can only be achieved in a pooled investment such as in bond funds.
Investors in bond funds do not feel the cost burden that comes with diversification.
This is the ease at which bonds can be sold. In any investment, liquidity is considered a good thing. It gives you the flexibility and the ability to change your investments from one form to another.
Since individual bonds are never sold before maturity, they tend to be less liquid.
Bond funds are more liquid since they can easily be sold in the secondary market.
Treasury bonds issued by the government are even more liquid because they are always in demand.
If you have no idea how to make good investment decisions, then you can fit well in bond funds. As mentioned earlier, bond funds are companies themselves. They are managed by professionals who are highly qualified investment analysts.
Having them run your investment, means you are spared the headache of having to make tough investment decisions.
Due to expert management, bond funds have a better chance of yielding higher returns.
Individual bonds do not have specialized management. As a bondholder, you’d have to make investment decisions by yourself.
If you like being in control of your investments, then you should go for individual bonds instead of bond funds.
When you invest as an individual, all decisions will rest on you. This would work well if you have a financial background. Otherwise, you’d have to rely on financial consultants who wouldn't come for free.
On the bright side, when you invest in individual bonds, you have the power to select which companies to invest in. you can use this power to select companies that you think will give you the highest return.
Investing through bond funds gives you less control over the investment. The fund is operated by managers. The only part you play is in the appointment of the managers.
If you do not like the way the bond fund is invested by the fund manager, there is not much you can do about it.
The decision to invest in individual bonds or bond funds depends on many factors such as risk, cost, the need to be in control of the investment, and the need to have a skilled person take the wheel.
Individual bonds have a fixed interest rate and a fixed maturity period. Bond funds, on the other hand, can be sold before maturity, and the interest paid to investors is not fixed.
Individual bonds interest is paid twice a year while bond funds interest is paid every month.
Having known the differences between these two, it is now up to you to choose the investment option that appeals the most to you.