Bonds? Bond funds? Vive la difference!
Confused about the difference between bonds and bond funds? You’re not alone. Here’s a primer to help you become a savvy investor who understands the difference between the two investments , and the roles they play in your portfolio.
A “Bond” is a debt obligation, issued by an entity such as a corporation, publicly-owned utility, or government. When you buy a bond, you are lending your money to that entity for a set period of time. In return, you are paid interest until the end of that period, at which time you receive the money you loaned (or the ‘principal’) back.
“Bond funds” are mutual funds that invest in many bonds. Most hold one type of bond. They are also defined by the time held – short term, less than 3 years; intermediate-term, 3 to 10 years; and long-term, 10 years or more.
Difference in price, interest rates and net asset value
“Bonds” are usually held by the investor (you) until maturity. You receive interest (or ‘fixed income’) for a specified period of time. The price of the bond may change over time, but you receive all of your initial investment when the bond matures.
“Bond funds” are valued by the net asset value (NAV) of the underlying holdings in the portfolio. If bond prices fall, investors can lose some of their principal investment. (And conversely, they’ll benefit if bond prices rise.) Therefore, bond funds carry greater market risk than bonds.
When to buy bonds and bond funds
Bond prices tend to move in the opposite direction as interest rates, so when interest rates are expected to rise, investors often consider adding individual bonds to their portfolio. When interest rates are expected to decline (and bond prices rise), bond mutual funds may be a better choice.
Some fixed income investors like to combine bond mutual funds with individual bonds in their portfolio as a diversification strategy.
Although bonds and bond mutual funds are generally considered ‘safe’ investments, risks do exist.
With bonds, the primary risk is the potential for the issuing entity to default. It’s wise to check the entity’s credit rating with agencies such as Standard & Poor’s. In addition, it’s a good idea to diversify into different industries.
Bond funds can also lose principal and carry more market risk than individual bonds, especially in economic environments where interest rates are rising.
Whether held to maturity or sold beforehand, you can calculate your return on an individual bond. With a bond fund, you generally won’t know how much you’ll receive in any year, because the fund itself doesn’t have a maturity date. Income fluctuates as the underlying investments change. Returns may be a combination of interest and capital gains.
Buying and selling
You can hold an individual bond to maturity or sell it beforehand (but the ability to sell will depend on the type of bond). Bond funds can be bought or sold any time, but there may be a sales charge and commission.
Commissions are built into the price of an individual bond. With a bond fund, you are charged management fees and operating expenses (MERs).