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Should you invest in individual bonds or bond funds?

By Rick Imhoff, CFP ®

Many wealth managers suggest including bonds in your investment portfolio regardless of where the bond or stock market is at any given time.  Owning bonds help diversify your portfolio.  But should you invest in individual bonds or bond funds?

Investing in individual bonds offers several advantages over bond funds.  First, you know exactly what you’re getting in the way of interest payments and maturity.  You lock in the price, the yield to maturity or call, and the cash flow.  You can buy an individual bond with a maturity date that matches a specific investment goal, such as a child entering college. With a bond fund, earnings aren’t fixed and the fund never matures. It is designed to maintain a certain average maturity or duration.

Short of default, an individual bond will return all principal and pay all interest assuming you hold it to maturity or it is called early.  Bond funds are not likely to default, though individual issues in the fund might, but they can’t promise full return of principal at maturity.  This is because the issues in the fund are always changing to meet the investment objective of the fund.  With individual bonds, you can choose when to buy or sell a particular bond, which has tax and cash flow advantages.

Individual bonds also don’t incur the ongoing management and operating expenses of bond funds.  Of course, individual bonds have their associated expenses, including brokerage commissions or fees, bid-ask spread and the cost of selling individual issues.

The big advantages of bond funds are diversification, liquidity, purchase cost, the availability of reinvested dividends and professional management who takes care of all the details from analyzing the credit markets to choosing which bonds to buy and sell.  You can create something similar to a bond ladder with bond funds by purchasing ultra-short, short, intermediate term, and/or long term bond funds.  You can easily shorten or lengthen your average maturity by placing more of your portfolio in the appropriate bond fund.  For example, if you want to shorten your average maturity, you may sell part or all of your position in the long term bond fund and buy shares in the short term bond fund. 

The generally high cost of buying individual bonds prevents many investors from sufficiently diversifying among different issues.  A bond fund might hold hundreds of bond issues, thus reducing nonpayment and default risk.  An individual investor should probably own at least ten or more bonds from different issuers, with the exception of Treasury securities, to achieve an acceptable level of diversification and reduced risk.

Selling shares of bond funds is typically much easier than selling individual bonds, although the market for Treasury securities and government agency bonds is quite liquid.  Investors concerned about early liquidation or quickly adjusting the average maturity of the bond portion of their portfolio may be better off sticking with funds.

For investors who don’t need the cash flow, reinvested dividends are another advantage for bond funds because they usually are automatically reinvested.  Interest from individual bonds, typically paid every six months, cannot be automatically reinvested.  Unless the interest is enough to buy a new bond, you’ll likely have to put it into a money market or savings account, where it will probably earn less interest.

Ultimately, the decision whether to buy individual bonds or bond funds comes down heavily on the size of your portfolio, your knowledge of the bond markets and your cash flow and investment needs.