There are both advantages and disadvantages to investing in Bonds and Bond Mutual Funds. The real reason for choosing which method depends on your situation and what you wish to accomplish. What are your goals?
Let’s examine both options.
The advantages of investing in bonds through a bond mutual fund are:
- Diversification: Bond mutual funds invest in 1000’s of different individual bonds, the fund is also owned by 1000’s of individual investors. Rarely do bond mutual funds invest more than 1% of their assets into any one bond, so funds are diversified. The bonds owned in the fund have many different maturity dates, different retying, and varying amounts. The actual type of bond fund can also dictate the level of diversification, as an example, a bond fund only investing in US Treasury Bonds would need little diversification while a fund investing in corporate bonds would need a wider level of diversification.
- Management: Bond funds are professionally managed. Bond managers are selected based on their experience and knowledge of the subject. Most bond mutual funds have ample research available to help gauge the bond market.
- Convenience: Instead of compiling your research as an individual bond purchaser, the bond mutual fund does that for you. Investors in bond mutual funds buy shares of the fund, daily the price of the shares owned is posted and is available to the investor.
- Dividends: Individual bonds pay interest once every six months, bond mutual funds pay dividends monthly (some occasionally quarterly). This is an advantage to investors who are using the bond fund as an income stream.
The disadvantages of investing in bonds through a bond mutual fund are:
- Interest Rate Risk: Bonds as a whole have a risk to them in relationship to overall interest rates. It is a simple inverted interest topic; if interest rates increase, an investor having to sell a bond or bond fund will receive less than their initial investment. The opposite is true when interest rates decrease the value of currently owned bonds will increase.
- Unstable income: Because bonds within a bond mutual fund are bought and sold regularly, the actual amount of the monthly dividend can be unpredictable. There is no way to know with certainty what interest rates are going to be in the future. A bond fund’s interest payments can fluctuate monthly based on the current bond portfolio and the earned interest.
- Taxes: When a bond mutual fund sells bonds, a taxable capital gain or taxable loss can be created. It is possible to earn a modest interest rate on your bond mutual fund dividends and still receive a taxable liability based on the activities of the bond mutual fund’s buying and selling of its assets. The percentage of assets sold on average each year is called the “turnover” rate, and as a bond mutual fund investor, it is important to know the tax liability of your bond mutual fund investments.
- Fees: Bond mutual funds contain fees, fees for acquisition, buying and selling of the portfolio, fees for daily operation, and often commissions paid to the sales firm. Make sure you fully understand the costs before investing; they are located in the prospectus.