The pros and cons of bond funds vs. individual bonds

The choice depends in part on where interest rates are headed, diversification and fees.

  • By Dan Weil,
  • The Wall Street Journal
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As stock-market volatility drives more weary investors into fixed-income markets, a big question looms: Do you invest in bond funds or individual bonds?

Unfortunately, there isn’t an easy answer. But each offers some benefits.

In a time of rising interest rates, individual bonds can carry an advantage. That’s because rising rates mean falling bond prices, which depress the value of bond mutual funds and exchange-traded funds. For 2018, U.S. open-end bond mutual funds and ETFs on average returned just 0.9%, according to research firm Morningstar Inc.

With individual bonds, if they are high-quality, investors generally can count on receiving the full par value if they hold to maturity. “Mutual funds are generally subject to more variability in a rising-interest-rate environment,” says Karim Ahamed, an investment adviser for HPM Partners in Chicago.

In a falling-rate environment, individual bonds lose that advantage, because bond fund prices will tend to increase.

So, which path investors take depends in part on where they think interest rates are heading. The Federal Reserve has been raising rates since 2015. But with the economic outlook so uncertain and financial markets so turbulent lately, experts are divided on the future path for rates. Some still believe the U.S. economy and inflation will be strong enough to prompt the Fed to lift rates further, while others say the central bank is more likely to at least pause its rate increases this year. On Friday, Fed Chairman Jerome Powell said mild inflation gives the central bank greater flexibility to set policy this year.

Diversification and fees

Other advantages of bond funds and individual bonds don’t depend on the course of interest rates.

For one, individual bonds offer more predictability in certain ways. In any interest-rate environment, investors generally know exactly what their interest-rate income will be from an individual bond, while interest payments can vary widely for funds. Investors also know exactly what their capital-gains taxes will be on individual bonds if they sell any; capital gains for bond funds are unpredictable.

But some experts say bond funds are better for creating a diversified portfolio. “Mutual funds give broader diversification: You can get exposure to many underlying bonds,” says David Carter, chief investment officer at Lenox Wealth Advisors in New York. “This is especially important when investing in riskier bonds, such as high-yield or emerging markets.” Illiquid trading conditions can make buying and selling individual bonds difficult in those markets.

Another disadvantage of individual bonds is that transaction fees can be high, especially when bonds are purchased in small amounts. The minimum denomination for a bond generally is $1,000. Considering fees and diversification, a rule of thumb is that investors need a minimum of $250,000 in at least 10 bonds for the individual-bond route to make sense, advisers say.

Fees are an issue for bond funds, too. The average annual expense ratio for U.S. open-end bond mutual funds and ETFs is 0.74%, according to Morningstar. The trading cost for an individual bond is about the same as one year’s expense fee for a mutual fund with similar bonds, Mr. Carter says. The difference, of course, is that you pay the expense ratio on your fund every year, while you pay a trading fee only once if you buy a bond and hold it to maturity.

Building a ladder

One approach for investors buying individual bonds is to construct a bond ladder—a portfolio of bonds of different maturities. As each bond matures, a new one is purchased, generally with the same length of maturity. This approach is designed to lessen interest-rate risk through diversification and provide reliable cash flow.

RDM Financial Group-HighTower in Westport, Conn., uses bond ladders for its clients, says Michael Sheldon, RDM’s chief investment officer. RDM’s ladders are made up of investment-grade corporate bonds and municipal bonds. “When a bond ladder is constructed, we know the yield to maturity and cash flows that the bond ladder is likely to generate,” Mr. Sheldon says.

However, investors who don’t have access to sophisticated advice and don’t have the capability to research individual bonds on their own are probably better off in a mutual fund or ETF, where an expert makes the investment decisions, financial advisers agree.

ETF vs. mutual fund

For investors who decide to invest in a fund, the next question is whether to buy shares in an ETF or a mutual fund.

ETFs have the advantage of lower fees—an average annual expense ratio of 0.326%, compared with 0.785% for open-end mutual funds, according to Morningstar. That makes ETFs appealing, experts say. With interest rates low by historical standards, limiting returns, it’s particularly important to focus on costs, says Tom Fredrickson, a New York financial adviser.

But ETFs have some issues. “We are somewhat wary of bond ETFs, because if there is a large amount of market volatility, ETF investors may not get the price they expect when they go to sell a bond ETF,” RDM’s Mr. Sheldon says.

That’s because the prices of ETFs, unlike those of mutual funds, can change throughout the trading day. So when volatility is high and the market prices for bond ETFs and their holdings are moving quickly, the ETFs’ prices may not match the value of their underlying assets at any given point during the day. Open-end bond mutual funds are priced only once a day, at their closing net asset value.

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