Key takeaways
- Individual bonds can offer predictable cash flows, but only if they are held to maturity and defaults are avoided.
- Bond funds provide broader diversification and professional management, but do not guarantee capital.
- Costs are often hidden in individual bond prices, while bond funds carry visible expense ratios.
For fixed income investors, the choice between owning individual bonds and investing in a bond fund can determine not only the returns, but also the predictability of your portfolio. Individual bonds are loans to a corporation or government that you can hold until maturity, while bond funds bundle many of those loans into a single, professionally managed investment. Both can serve as safe havens compared to stocks, but their risks, costs, and behavior in volatile markets differ more than many investors realize.
How Bonds and Bond Funds Are Different for Your Portfolio
The key difference is that an individual bond pays interest and returns principal at maturity (assuming no default), while a bond fund holds many bonds at once and continually trades them. While bondholders receive interest paid regardless of whether markets rise or fall, they still face risks if a borrower’s credit weakens or defaults.
To reduce the impact of a bad borrower, “people buy bond funds, a collection of various corporate and/or government bonds,” says Samantha Mockford, associate wealth advisor at Citrine Capital. Bond funds spread risk across many issuers, much like “stacking pancakes and cutting a bite out of many thin cakes,” he adds. “This way, your investment won’t be affected by one or two unfortunate decisions.”
Matthew Hofacre, founder of Pay It Forward Financial Planning, warns that many investors don’t understand how these products behave and assume that bond funds will act the same as an individual bond. Individual bond values can fluctuate before maturity because they are traded on the open market, where prices change with interest rates, credit risk, and investor demand. Still, if they are held to maturity and the issuer does not default, they effectively “protect their principal” and have a set maturity value, Hofacre says. Meanwhile, the value of a bond fund also fluctuates with the market as the underlying bonds are bought and sold (rather than held to maturity), but the fund itself has no set maturity value.
Differences in costs
Buying an individual bond outright may seem free, but Alvin Carlos, managing partner at District Capital Management, notes that “the cost is built into the price” through the bond’s bid-ask spread. That cost can increase if you trade frequently before expiration. Other costs may also appear: although not always, Hofacre notes that custodians sometimes charge transaction fees per bond, such as $1 per bond, for example. And if you buy an interest-bearing bond on the secondary market, the buyer typically compensates the seller for the accrued interest.
Like individual bonds, bond funds also typically incur transaction fees; However, the key difference is that bond funds have transparent expense ratios. “A good low-cost bond fund can be found for as little as 0.03%,” Carlos says, and active managers in bond markets (where inefficiencies are greatest) are sometimes more likely to outperform indices than their stock fund counterparts.
Interest Rate Risk for Bonds and Bond Funds
Interest rates and bond prices move in opposite directions: When rates rise, the market value of existing bonds generally falls because new bonds offer higher yields, making older, lower-yielding ones less attractive. With a laddered portfolio of individual bonds (a strategy in which bonds with staggered maturity dates are purchased) “maturities are controlled, so that when short-term bonds mature, they can be reinvested at new rates,” Carlos says. This constant renewal of bonds can make future cash flows more predictable in a rising interest rate environment and help soften the impact of rate changes over time.
Meanwhile, bond funds are “constantly buying and selling, so the portfolio never ‘matures,’” Carlos says. This means that a fund’s performance may take longer to adjust upward after rates rise. Additionally, Hofacre notes that bond funds often pay monthly dividends, which can be attractive to investors who need stable income, although the value of the fund itself may still decline.
The conclusion
There is no universal winner in the debate between individual bonds and bond funds: what matters are goals, timeline, and tolerance for market swings. If you value fixed cash flows for specific future needs, holding individual bonds to maturity can offer stability. If you want broader diversification, professional oversight, and easier reinvestment, then a low-cost bond fund may be more useful to you.
As Carlos says: “A typical investor will usually be better off buying a low-cost bond fund, as long as he or she is prepared to suffer losses during years when interest rates rise.”
