Bonds Vs. Bond Funds

Quoted on (9.23.09)
Bonds Vs. Bond Funds
By Roger Fillion

You’ve decided your portfolio needs bonds. Now you have to decide: Will you invest in mutual bond funds or individual bonds?

You’ll first want to weigh several factors. Your ultimate decision will depend on how much money you have to invest, your risk appetite and whether you have a goal, such as buying a house or funding college tuition. Then there’s the question of whether you want to spend much time researching and monitoring your holdings.

Bond mutual funds, in particular, have been popular since last fall’s financial meltdown. In July alone, investors poured $35.1 billion into bond mutual funds, according to the latest data from the Investment Company Institute. That’s more than triple the $9.8 billion stock mutual funds took in that same month.

“Buying an actively managed bond fund creates a more diversified portfolio and may mitigate the damage from defaults and ratings downgrades,” said Ford O’Neil, manager of Fidelity’s Total Bond Fund (FTBFX ) .

To be sure, there’s no right or wrong to the question of bonds versus bond funds. The two are vastly different:

** Individual bonds pay a fixed stream of income, generally semi-annually. They return your principal on a specific date if held to maturity

** Bond funds invest in many securities with different interest, or coupon, payments. The income received from the bonds is distributed monthly to shareholders. The distribution may vary month to month. The fund’s value also varies daily

“We find people who own one or the other, and people who own both,” said Richard Carter, vice president of fixed-income inventory at Fidelity Investments.

Why bonds, otherwise known as fixed-income securities? Because bonds can generate steady income in a diversified portfolio, and they tend to move in the opposite direction of stocks – but not always.

“Bonds are an important way to buffer a stock portfolio and at the same time provide you with compounded interest,” said James Swanson, chief investment strategist at MFS Investment Management in Boston.

Safer, lower-yielding bonds include: Treasurys, investment-grade corporate bonds, municipal bonds and bonds issued by government-sponsored agencies such as Fannie Mae . Riskier, higher-yielding bets include corporate bonds rated below investment-grade, also known as “junk bonds.” Here are some of the pros and cons of bond funds and individual bonds.

Why bond funds

Diversification: Funds offer diversification with less money. With a few thousand bucks, you can buy shares in, say, a corporate bond fund. They often hold bonds from hundreds of companies, so you’re shielded if a few companies default. By contrast, your returns suffer if you own a limited number of bonds from a handful of companies and an issuer defaults. Plus, it’s not cheap to build a diverse portfolio.

“It would be difficult to efficiently create a diverse portfolio of corporate bonds with much less than $100,000,” said Clint Edgington, president of Beacon Hill Investment Advisory, a fee-only investment advisory firm in Columbus, Ohio.

Price: A fund lets you buy a bond portfolio at the bid, or buyer’s price – versus the higher selling, or ask, price in the market. By contrast, investors buying individual bonds often pay the higher price.

“When an investor buys a $1,000 face value individual bond they’ll always pay the ask price, which for even more widely traded corporate bonds can be $20 higher than the bid price,” said Todd Burchett, manager of ICON Bond Fund (IOBIX ) at ICON Advisers, a mutual fund company in Greenwood Village, Colo. The bid-ask spread for more thinly traded corporate junk bonds can be as much as $200.

Research: Bond funds rely on credit research departments to analyze an issuer’s credit risk.

“It’s probably difficult for most retail investors to have the background or the knowledge to buy individual bond holdings,” said Lowell Bennett, fixed-income strategist at Mellon Capital, which manages several Dreyfus Corp. funds.

Fidelity’s O’Neil noted that during the past few years “some of the worst performing bonds” have been large companies or other issuers that are commonly held in bond index mutual funds. “A firm with deep research can potentially avoid or sell these bonds before trouble arises,” he added.

Liquidity: You can sell fund shares any time at the fund’s current value. Selling an individual bond often is tougher, if you must sell before maturity. They trade less frequently than stocks. And bonds typically trade “over the counter,” meaning a broker hooks up buyers and sellers who negotiate price. Riskier bonds can be harder, and thus costlier, to unload.

Why individual bonds

Predictability: You know the date your bond matures, and the interest payment is fixed. A bond’s price will fall if market interest rates rise, but you’ll be paid the bond’s face value if you hold it until maturity – assuming the issuer doesn’t default. “You don’t have that security blanket with funds,” Beacon Hill’s Edgington said.

Income: Individual bonds allow you to generate a specific income stream. That’s important if you’re looking to fund, say, a new home or retirement. You can create a “ladder” of individual bonds with different maturities and income payment schedules to meet your income needs and investment time frame.

“A ladder plays on the notion that bonds have the ability to be modeled to create a specific cash flow,” said Fidelity’s Carter.

Cost: With some effort, you can slash costs in certain cases by buying bonds directly from an issuer, without a mark-up or commission.

The U.S. Treasury’s TreasuryDirect program allows you to buy securities directly from Uncle Sam. Municipal bond issuers such as states and cities offer “retail order periods” allowing you to spend $5,000 to buy munis directly. Similarly, Fidelity’s CorporateNotes program allows you to buy bonds directly from certain companies. Bond funds charge management fees. Some levy a charge when you buy or sell.

Control: You know exactly what you own when you buy individual bonds – the maturity date and interest rate. You choose what to buy. “There’s a bit of a sense of control when you own your own positions,” said Wes Moss, chief investment strategist at Capital Investment Advisors, a fee-only advisory firm in Atlanta.

Experts said wealthier individuals are good candidates for individual bonds. They’ve got cash to build diverse portfolios, although it doesn’t take as much money or effort to craft a portfolio if you’re focusing solely on safer and more widely traded securities such as Treasuries.

Individual bonds or bond funds can be a good bet. But which way is right for you depends on your own needs, your financial situation, your tolerance for risk, the time you have and the amount of research you want to do.

Given the complexities, bond funds probably are the right choice for many investors. Many, but not all.