On Tuesday, when I was speaking to our Pittsburgh AAII chapter, a member asked whether it is better to buy bonds or bond funds. The answer, as I explained to him, is not simple or straightforward. Rather, it depends on a combination of factors.
Bond funds offer ease and simplicity. A bond fund gives you instant access to a diversified portfolio of bond holdings. I own a bond fund because it makes it easier for me to get fixed-income exposure. The downside is that the typical bond fund, unlike an actual bond, never matures. The price of a fund's shares and the cash flows you receive will depend on the bond market's fluctuations-which are influenced by changes in interest rates-and, of course, the manager's skill. So, bound funds lack a guaranteed rate of return. Furthermore, with a bond fund you will pay ongoing annual management expenses and have no ability to control the timing of capital gains.
Bonds offer a higher (but not absolute) level of predictability. A bond held to maturity will provide a fixed rate of return. At a pre-specified date, you will get the face ("par") value of the bond back, typically $1,000 per bond. In addition, you will receive semiannual interest ("coupon") payments. Both of these amounts are fixed for traditional American bonds. Because they are fixed, you know your pretax rate of return when you purchase the bond. This rate of return does not alter so long as you keep the bond to maturity. This is why some bond experts suggest buying actual bonds as opposed to bond funds.
The key is to hold the bond until it matures. Individual bonds offer limited upside, but the risk of a complete loss of your invested capital on the downside, as fund manager Jason Brady explained in the AAII Journal. The primary upward drivers of a bond's price are a decline in interest rates or a credit rating upgrade. Limiting the magnitude of the upside is the fixed return that bonds offer when held to maturity. Excessively overpay for a bond and you will lose money unless you can find someone willing to pay even more. The downside is the potential for losing your entire investment if a default occurs and there are not enough assets to repay you. (A bond is essentially a loan to the issuer.) Defaults tend to be limited among high-credit-quality bonds (though they can occur), which is why bonds are viewed as providing preservation of capital. (In contrast, stocks offer return on capital.)
Bonds can be more difficult to buy than stocks. A single company may issue many bonds. Using General Electric (NYSE:GE) as an example, the company has only one class of common stock that is publicly traded, GE. There are many issues of General Electric bonds, however, with differing maturity and coupon rates. (A search on FINRA's website identified 500 bonds associated with General Electric.) Thus, while you can call your broker and simply say "buy me X number of shares of GE stock," you can't do the same with GE bonds. You will have to give the CUSIP number (the bond equivalent of a stock ticker) or least the maturity or yield you desire. Since there are multiple issues, liquidity (the number of active buyers and sellers) will also differ. Depending on what you are trying to buy and the amount you are looking to invest, it may be challenging to complete a trade.
Thus, the decision as whether to buy a bond or a bond fund should be based not only on your goals, but also on the size of your portfolio, your personal preference about how involved you want to be with your portfolio and whether you want to work with a financial professional who is skilled in building and managing a bond portfolio.
Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors and editor of the AAII Journal.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.