BONDS ARE COMPLEX -- there's no doubt about it -- especially if you're a novice investor with little experience in the markets. That's why a lot of people opt for the greater simplicity offered by bond funds when they seek to diversify their investments with some fixed-income exposure. Our view is that if you're willing to put in the effort (and the cash), you may be better off buying individual bonds instead of bond funds. But in the real world, a fund is sometimes worth the convenience.
Here's what you have to consider:
Like an equity mutual fund, a bond fund is managed by a professional investor who buys a portfolio of securities and makes all the decisions. Most funds buy bonds of a specific type, maturity and risk profile -- long-term corporates, for instance, or tax-free municipals -- and seek to pay out a coupon to investors -- often monthly, rather than annually or semiannually like a regular bond.
The chief advantage of a bond fund is that it's convenient. It's also true that when it comes to buying corporate and municipal bonds, a professional manager backed by a strong research organization can make better decisions than the average individual investor. Consequently, if your goal is to dabble in junk bonds or shelter your income with high-yield muni bonds, you may be better off going the easy route and picking a good fund.
Of course, the cash outlay required to build a decent bond portfolio could be another reason why a bond fund might make more sense for you. Bonds -- especially municipals -- typically sell in $25,000 lots to individual investors. And while you can find a few offerings in the $10,000 or even $5,000 range, you won't have as much selection. So if your nest egg is not yet large enough to comfortably meet the high minimums associated with building a diversified bond portfolio, bond funds may be a good alternative. These funds typically have minimum investment requirements of just $1,000 to $3,000.
The disadvantage of a bond fund is that it's not a bond. It has neither a fixed yield nor a contractual obligation to give investors back their principal at some later maturity date -- the two key characteristics that are the goal of individual bonds. Then there are the fees and expenses that can cut into returns. Finally, because fund managers constantly trade their positions, the risk-return profile of a bond-fund investment is continually changing; unlike an actual bond, whose risk level typically declines the longer it is held by an investor, a fund can increase or decrease its risk exposure at the whim of the manager.
The other thing about building your own portfolio of bonds is that you can tailor it with a goal of meeting your circumstances, meaning you can purchase bonds that are set to mature when you need them. For instance, many parents saving for college bills buy zero-coupon bonds whose maturities match their child's enrollment year. You cannot do that with a bond fund.