Bonds bring lower rates of returns than the stock market, but they also generally bring fewer risks. Your risk tolerance, diversification goals and need for fixed payments and liquidity will affect your choice of individual bonds or bond mutual funds. For the average investor, mutual funds are the easiest and most cost-effective way to own bonds.
Individual Bond Basics
Most individual bonds pay a fixed amount of interest periodically, usually twice a year. Upon maturity they return the principal, which is the face value of the bond. When you buy them, you pay a commission to the bond broker or dealer.
Since you're managing your own investment, it’s up to you to research the bonds and their credit ratings before you buy. You can buy taxable bonds, corporate or government, which usually have higher yields. Depending on your personal tax situation, you may prefer tax-free municipal bonds. Municipal bonds pay lower interest rates, but they may offer a welcomed tax shelter if you're in a high tax bracket.
Individual Bond Risks
You can sell a bond before it matures, but you're vulnerable to current market conditions and may get more or less than the face value. You may have a hard time unloading some bonds if their value has dropped.
Sometimes bonds get called before maturity, which means the bond issuer has decided to repay the full face value ahead of the scheduled time. This often happens when interest rates go down and bonds then get reissued at a lower rate, in which case you may have difficulty finding a new bond with equally favorable terms. To achieve diversification with individual bonds, you need to purchase numerous ones issued by different companies and/or municipalities. If you hold only a couple of bonds and one of them defaults, you could lose a big chunk of money.
Bond Mutual Fund Basics
Since bond mutual funds hold a large number of different bonds, you have instant diversification. Though a fund can’t be any safer than the funds that make up its portfolio, the failure of one or two would have a minimal impact, because they're only a small piece of a big puzzle.
You do pay expenses such as management and other fees, but they're likely to be lower than commissions paid to individual bond dealers. Funds are professionally managed by experts who do the research for you. For many investors, a major benefit of bond funds is that they are fully liquid, and you can buy and sell each day at the current price. They also require a smaller initial investment than individual bonds, so if you’re just starting out, they may be your only option.
Bond Mutual Fund Risks
You can't rely on bond mutual funds to return face value like individual bonds do. Bond mutual funds always have a market risk, but it's diffused, since you hold bonds from a range of issuers. You can redeem shares at any time, but you're subject to paying taxes on any capital gains and may have to pay redemption fees. Since bonds within the portfolio are regularly bought and sold, you can’t rely on a fixed income the way you can with individual bonds, because payments will vary as bonds are bought and sold.
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