There are unique risks and benefits to investing in either individual bonds or in bond mutual funds. We have detailed a few of these risks and benefits below.
Price Stability of Individual Bonds vs. Mutual Funds
- When buying an individual bonds, you know with certainty (absent a default event), when that bond will mature and return the principal value.
- Bond mutual funds have no set maturity date, and often buy and sell underlying holdings rather than letting them mature.
During the lifetime of a bond, changes in interest rates will affect the value of that bond. When you hold an individual bond to maturity, the changes in value of the bond over the holding period are temporary. You will receive the par value of the bond on its maturity date.
Unlike individual bonds, any changes in value of a bond mutual fund are more important. This is because there is no maturity date at which the fund will regain its par value. The loss of value can be further exacerbated in rising interest rate environments when investors tend to sell these funds off. For example, in the first half of 2022, there has been nearly $300 billion in net outflows from these funds. This can require the fund manager to sell underlying assets (often at unattractive prices) to cover those redemptions, leading to further erosion in the value of the bond fund.
Diversification & Control of Individual Bonds vs. Mutual Funds
- A ladder of individual bonds will, in general, be less diversified than a bond mutual fund.
- Bond mutual funds allow for a high level of diversification independent of investment size.
Investing in individual bonds limits diversification within our fixed income strategies. With this said, it also gives us complete control over the issuers, quality, and maturity ranges of the holdings within our bond portfolio. By having increased control, we can avoid certain geographic areas, economic sectors, and individual issuers that could see problems in the future according to our macroeconomic outlook. While bond mutual funds are more diversified, there is also the opportunity for them to stray into sectors that may not be appropriate for our clients from a risk standpoint.
Predictability of Income & Capital of Individual Bonds vs. Mutual Funds
- Individual bonds make coupon payments on a predetermined schedule with a predetermined amount. (Corporate bonds generally make coupon payments every six months.)
- Bond mutual funds pay dividends monthly in amounts that are determined by the coupon payments of the underlying holdings.
While the monthly income of bond mutual funds can be attractive, it is difficult to plan around given the fluctuating amounts paid out each month. Coupon payments of individual bonds can be a great planning tool for upcoming expenses like a child’s college tuition or a planned vacation. In addition, individual bond maturities can be structured to coincide with major, but predictable, expenses. For example, many will use individual bonds for recurring charitable gifts. This is because the bonds allow that money to provide predictable income without being subject to market fluctuations.
There are pros and cons to both individual bonds and bond mutual funds. At Godsey & Gibb, we choose to invest individual bonds due to the combination of stability, predictability, and control. If you have any questions about individual bonds versus bond mutual funds or your portfolio structure, please contact our team.
Individual Bonds – click here
Mutual Funds – click here
Author: Godsey & Gibb Investment Team
Written: July 21, 2022