Street$marts: Bond Funds and Individual Bonds–Six Differences That Impact Your Investment Strategy 

Charity DiCola, Fixed Income Analyst

One of the questions we get here often is about the differences between bond funds and individual bonds. While both are a great way to add some fixed income exposure to your portfolio, you’ll want to understand six key differences between the two so you can decide which is the right investment tool for you.

Hi, I’m Charity DiCola, Fixed Income Analyst at Howe and Rusling Wealth Management. One of the questions we get here often is about the differences between bond funds and individual bonds. While both are a great way to add some fixed income exposure to your portfolio, you’ll want to understand six key differences between the two so you can decide which is the right investment tool for you. 

Let’s first clarify what a bond even is. A bond is a way for an official organization to borrow money from the public. These organizations could be corporations, like Apple or Walmart, municipalities, like Monroe County or the City of Rochester, or even the federal government. An investor will buy the bond from (or in effect, lend money to) the organization and receive interest payments, called coupons, as a percentage of the face value for the life of the bond. For example, a 5% coupon bond with a face value of $5,000 will receive $125 semi-annually until the bond matures. When the bond matures, the investor will receive the $5,000 principal back along with the final interest payment. 

Now that we know what a bond is, let’s dig into the differences between individual bonds and bond funds. 

1. Nature of the investment 

  • When you’re purchasing individual bonds, you’re actually choosing who you want to lend money to, how much you want to be paid for lending that money, and the amount of time you’re willing to lend it. 
  • Bond funds can be mutual funds or exchange traded funds. They pool money from a group of investors to purchase a large number of bonds. They typically pay a monthly dividend, which is basically the interest payments less any fees. Investors in bond funds are still lending money to the companies, municipalities, or federal government, but in a more roundabout way. 

2. Diversification 

  • Diversification in a bond portfolio is when there are a range of bonds included. These bonds will be a mix of corporate and government bonds, and they’ll be from different company names, different business types, different business sizes, and different maturities. This is an absolute necessity when building an individual bond portfolio so market movements don’t skew the portfolio’s performance. Since the manager of an individual bond portfolio must be intentional in including a range of bonds, it is important to maintain account minimums. A smaller account will not have the capital to purchase enough bonds to properly diversify the portfolio. 
  • Bonds funds, on the other hand, are typically well-diversified by nature and easily provide access to a range of bonds across various issuers, sectors, and maturities. They are a great option for smaller accounts because the buy-in for proper diversification is much lower. 

3. Management and costs 

  • Investors who want to own individual bonds often hire their own professionals to build and manage their bond portfolios, which includes researching, selecting, and monitoring bonds. Costs for this service vary and are typically expressed as a percentage of the assets under management. 
  • Bond funds are actively managed by portfolio managers who make investment decisions on behalf of the fund owners. Investors who own shares of the fund pay an annual management fee called the expense ratio, which is also calculated as a percentage of the assets under management. There may be other costs associated with the fund as well, especially mutual funds, such as additional management fees, transaction costs, or sales commissions. Adding these all together means the investor typically pays more to be invested in bond funds than individual bonds, and bond mutual funds tend to be more expensive than bond ETFs. 

4. Customization and control 

  • Individual bond portfolio managers can build a custom portfolio using any number of desired specifications. Some common restrictions are income thresholds, maturity requirements, and specific businesses or business types to avoid. Bond fund managers, on the other hand, are held only to the objectives of the fund and are unable to accommodate investors’ unique situations. 
  • Owning individual bonds provides better control over knowing the actual yield to maturity (YTM). When you buy an individual bond, you lock in a fixed interest rate and know the exact yield you’ll earn if you hold the bond until maturity. This certainty allows you to plan for your income and investment returns with precision. In contrast, bond mutual funds do not offer the same predictability because their yield to maturity fluctuates with changes in the portfolio’s composition and market interest rates, making it harder to forecast your exact returns. 

5. Risk

  • Individual bonds carry a few specific risks. There is credit risk, or the risk that the issuing entity will default on their loan obligations. There is interest rate risk, or the risk that interest rates will rise, and the value of the bond will decline. There is also liquidity risk, which occurs when the bond won’t sell in the secondary market at a fair price. However, much of this risk can be mitigated by purchasing high quality bonds and holding them to maturity – that way, you know you will receive the interest payments and the bond will mature at face value. 
  • Bond funds face similar risks as individual bonds with a few nuances. The interest rate risk for a bond fund is greater because bond funds do not mature. Investors who need capital are required to sell shares at the market price, which means they may not recover their original investment. Funds also face redemption risk, or the risk of capital losses if many investors sell their shares at the same time during adverse market conditions. 

6. Predictability 

  • Individual bonds are far more predictable. Regardless of what happens in the market, a portfolio of high-quality bonds will pay interest on time and investors will receive their full value at maturity. The same cannot be said of bond funds, where any number of market conditions will affect the value on any given day. 

Individual bonds and bond funds are both great ways to gain exposure to the fixed income market. While many investors will benefit from some portion of their portfolios being invested in this market, defining your appropriate exposure comes down to determining your investment goals, risk tolerance, time horizon, and account size. Howe & Rusling’s Team of advisors can help you navigate what exposure is best for your specific circumstances. 

Disclosures This material is for informational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any securities or investment products. Past performance is not indicative of future results. Investing involves risks, including the possible loss of principal. Bonds are subject to interest rate risk. As interest rates rise, bond prices fall. Bonds are also subject to credit risk, where the issuer may default on payment of interest or principal. Bonds are subject to various other risks including but not limited to market risk, inflation risk, and liquidity risk. Bond mutual funds and exchange-traded funds (ETFs) are subject to management fees and other expenses. Please refer to the fund’s prospectus for a complete description of fees and expenses. The value of bond fund shares may fluctuate due to changes in interest rates, market conditions, and the credit quality of the underlying bonds. Redemption risk is present in bond funds, where adverse market conditions can lead to capital losses if a significant number of investors sell their shares simultaneously. Unlike individual bonds, bond funds do not have a fixed maturity date, which may impact the predictability of returns. While diversification may reduce risk, it does not eliminate the risk of loss. The level of diversification needed for an individual bond portfolio may require a substantial investment to achieve. Investors in individual bonds may incur costs for professional management of their bond portfolio, which are typically expressed as a percentage of assets under management. Bond funds incur annual management fees and other potential costs. Bond mutual funds generally have higher fees compared to bond ETFs. Individual bond portfolios can be customized to meet specific investment criteria, which may not be possible with bond funds. Bond funds are managed according to the fund’s stated objectives and may not be tailored to individual investor preferences. Investors should consult with their financial advisor to determine the suitability of bonds or bond funds based on their individual financial situation, investment goals, risk tolerance, and time horizon. This material is intended for informational purposes only and is not intended to be relied upon as a forecast, research, or investment advice. Howe & Rusling makes no representations or warranties regarding the accuracy or completeness of the information contained herein. Investors should seek their own financial, legal, and tax advice before investing. 

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