Bonds vs. Bond Funds: Which Is Right for You?

"Should I own individual bonds or bond mutual funds?"

It's a question we're asked frequently, especially by those worried about the effects of rising interest rates. If you're not familiar with the ins and outs of each option, it can be hard to decide may be best for your needs.

There are pros and cons to each approach, and which option may be best for you comes down to your personal investment goals, including your time horizon and risk tolerance.

This article discusses bond mutual funds—if you’re interested in bond exchange-traded funds (ETFs) and how they compare with mutual funds, check out ETFs vs. Mutual Funds: It Depends on Your Strategy.

Bonds typically pay semiannual coupon or interest payments and have fixed principal values—also known as face or par values—that are repaid at maturity. Although the par values are generally fixed, the price of a given bond can fluctuate in the secondary market depending on the direction of interest rates. When rates rise, bond prices typically fall, and vice versa. As the bond approaches its maturity date, its price generally will converge with its par value. Holding a bond to maturity does come with an opportunity cost: If rates rise while you're holding the bond, you could miss out on the higher coupons offered by newer bonds on the market.

The key benefits to owning individual bonds, barring bond default, are:

• A reliable income stream that is great for planning: If an investor has periodic upcoming expenses, like college tuition, having a reliable income stream can be great for planning.
• A predictable value at maturity: Assuming the bond is not callable (eligible to be called back by the issuer at or above par prior to its maturity date), you will receive the par value of the bond at maturity, barring default. Knowing this may help you ignore potential price fluctuations for the bond if you plan on holding it to maturity.
• Your own cost basis: With individual bonds, the price you pay to purchase the bond, and the amortization of any premium or discount for the bond, forms your cost basis. This feature is useful for tax-planning purposes.

The downsides to owning individual bonds are:

• You need a significant amount of bonds to achieve diversification. There are many sub-asset classes within the fixed income market, and diversification may be difficult to achieve using only individual bonds. Along with diversification among sub-asset classes, diversification across issuers is also crucial. The amount you have to invest to achieve this level of diversification¹ might be cost prohibitive for some investors.
• Pricing is generally less attractive than the pricing institutional investors receive. Institutional investors—those who purchase large quantities of bonds at one time—generally receive better pricing than individual investors. It is important to examine the price you are paying when purchasing individual bonds.
• It takes a significant amount of time to research individual bonds and manage a strategy for the bonds. There are thousands of individual bonds from thousands of individual issuers that are available to buy. Researching the issuer alone to get a sense of its creditworthiness often isn't enough—most issuers have multiple bonds outstanding, each with its own characteristics. Taking this all in, it's a comprehensive process to make sure you're owning the bonds that are right for you. Even after investing in a portfolio of bonds, managing the holdings can still be time-consuming.

Bond mutual funds usually hold a large number of bonds with a variety of issuers, maturity dates, coupon rates and credit ratings. Unlike individual bonds, which usually make semiannual interest payments, bond funds usually make monthly distributions that can be paid directly to the investor or reinvested into the fund to compound returns. One key difference between individual bonds and bond funds is that with bond funds, there's no guarantee that you'll recover your principal at a specific time, particularly in a rising-rate environment.

The key benefits to owning bond funds are:

• Greater diversification per dollar invested: It is much easier to achieve a diversified bond portfolio per dollar invested using a fund, because you obtain exposure to a basket of bonds within the fund.
• Access to institutional pricing: Bond funds generally receive better pricing on individual bonds than individual investors do. All else being equal, a lower price means a higher yield.
• Professional management: Some of the riskier segments of the fixed income market, like high-yield bonds, bank loans or preferred securities, have many nuances. They require a good knowledge of industry trends and credit analysis to navigate them successfully. If the fund is more actively managed, it also allows for the manager to buy or sell bonds depending on the economic and interest rate environment, potentially increasing returns and income.

The downside to owning bond funds is:

• The management fee: Management fees for the more actively traded bond funds can be higher, which may lead to lower returns. In contrast, when owning individual bonds, there's usually a commission charged when the bond is purchased, and unless it's sold prior to maturity, there are no other charges.
• The net asset value (NAV) will fluctuate with the market: As interest rates rise and fall, the NAV of a given bond fund will fall and rise respectively, and there's no certainty as to what the NAV may be at a point in the future. This makes bond funds less attractive than individual bonds when planning for future liabilities.
• Different cost basis and tax consequences: Bond funds pool money in order to purchase the bonds in the portfolio. With pooled funds, your cost basis for tax purposes won't be as simple as if you had purchased an individual bond and held it to maturity. Additionally, you do not have control of the buying and selling of the individual bonds, which can lead to capital gain distributions at the end of the year. These capital gain distributions can be hard to anticipate and plan for from a tax standpoint.

All of the pros and cons for individual bonds and bond funds need to be placed into the context of your preferences and circumstances. What works well for you might not work well for others, and vice versa. The table above is a good starting point for deciding what is better for you. There are three important considerations when determining whether an individual bond or bond fund is better for you: the amount you have to invest, your financial goals and your behavioral preferences.

The amount of assets you have to invest in your bond portfolio is a key consideration when determining whether to invest in individual bonds or bond funds. Individual bonds have denominations that can be cost-prohibitive for some investors. Add in how many individual bonds an investor needs for sufficient diversification, and the dollar amount continues to rise. For some, it might make sense to use a more accessible bond fund, or a combination of bond funds with individual bonds.

Financial goals are another important factor to consider. If you are looking for predictable value and certainty for your financial goals, then individual bonds may be a better fit. Meanwhile, if you are looking for professional management and want greater diversification for your financial goals, then bond funds may be a better fit.

Behavioral preference is another important consideration. If seeing the NAV of your fund fluctuate and having no control over certain tax consequences makes you uncomfortable, then bond funds might not be the best solution for you. It is important to realize that while you cannot eliminate the emotions involved in investing, you can recognize how a certain investment might make you feel and adapt your investment choices accordingly.

In the long run, the difference in performance between a portfolio of individual bonds and a bond mutual fund with the same duration and credit quality, held for the same amount of time, is likely to be small, because most of what an investor gets out of investing in bonds is the income generated by coupon returns, rather than the price change. The key is to make sure the investment vehicle you choose aligns with your goals and time frame.

There's no one right answer—bonds or bond funds—for every investor. The decision often comes down to the amount you have to invest, the preference for a professional manager, and the need for a predictable value at maturity.

Holding individual bonds generally requires more time and effort by the investor, but a Schwab fixed income specialist can help get you started. For bond funds, knowing your risk tolerance and investment time horizon makes selecting bond funds much easier. The Schwab Mutual Fund OneSource Select List^® can help streamline the process even further, enabling you to screen a high-quality group of funds based on these criteria.