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Should I Invest in Bonds or in a Bond Mutual Fund?

May 27, 2014

Bond funds are a fine choice for most investors, but individual bonds have one advantage funds can’t match.

As with stock mutual funds, bond funds allow you to instantly get a diverse portfolio of bonds with a small initial outlay. This is especially important if you are buying corporate or international bonds, since you may face high minimum purchases on each bond. For a very low cost—about 0.2% or less of assets per year—you can buy a bond index fund that gives you exposure to the entire U.S. bond market, with a mix of government and corporate bonds.

Individual bonds do have one advantage over most funds, though. If you want to be certain of getting back your money at a specific date, you can hold a U.S. Treasury bond to maturity. (Unlike with corporate bonds, diversification isn’t an issue. All Treasuries are backed by the U.S. government, and the feds have never defaulted.) Funds, which own a constantly changing mix of bonds, don’t have this feature. “If you own a bond fund, there is no maturity,” says investment strategist Pat Dorsey of Sanibel Captiva. The returns of a bond fund will fluctuate along with the current market value of the bonds in the portfolio.

The safety of holding a bond until maturity is often overstated, however. If you buy a Treasury and then interest rates rise, its market value if you tried to sell it will still fall, just like it would inside a mutual fund. The difference is that you aren’t getting an annual fund statement telling you so.

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