Bonds or Bond Funds?

INVESTORS WILL OFTEN tout the benefits of individual bonds, while disparaging bond funds. Why? Owners of individual bonds not only avoid fund expenses, but also enjoy a comforting degree of certainty. If you buy a seven-year bond, you know how much interest you will receive each year and what sum you’ll get back when the bond matures in seven years. By contrast, if you own a fund that focuses on bonds with an average maturity of seven years, you can’t be sure how much interest you’ll collect each year or what your fund shares will be worth seven years from now.

But the greater certainty offered by individual bonds is something of an illusion. While holders of individual bonds know their bond’s nominal value at maturity, they don’t know the inflation-adjusted value, unless they buy inflation-indexed bonds. Moreover, if interest rates rise, both individual bonds and bond funds will fall in value, and holders of both could potentially lose money if they’re forced to sell.

In addition, the performance difference between the individual bond and the fund likely won’t be that great—and the individual bond comes with greater risk. If you purchase an individual bond, you’re making a big bet on a single issuer, while a fund offers broader diversification. That big bet could come back to haunt you.

On top of all that, when ordinary investors buy individual bonds, they’re often charged huge markups, though you can sidestep this problem by purchasing new issues. A bond fund, meanwhile, should benefit from institutional pricing. Funds are also easier to buy and sell, plus you can reinvest your fund distributions in additional fund shares, no matter how small those distributions are.

That ability to reinvest is a key advantage, especially when interest rates climb. Yes, rising interest rates will depress the price of both individual bonds and bond funds. But with a fund, you can easily take advantage of those higher rates by reinvesting your distributions in additional fund shares.

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