Bonds and bond funds prove to have some significant differences that still baffle even those who invest regularly.
We've broken down the basics behind these largely differing terms:
What is a Bond?
Bonds are debt obligations – IOUs, if you will – issued by an institution, usually governments or corporations.
They’re typically issued in denominations of $1,000 and pay interest twice annually.
The interest rate is fixed throughout the term of the loan and the principal is guaranteed by the issuer upon the maturity of the bond.
How Do Bonds Work?
Let’s say you purchase a bond issued by a major corporation.
The bonds are being sold in denominations of $1,000 and offered by brokers in lots of 10, or $10,000.
The bonds have a term of 20 years and pay an annual interest rate of 5%.
On a $10,000 investment, you’ll earn $500 in interest per year. Since the interest is paid twice annually, you’ll receive two payments of $250 per year.
You will continue to receive $500 per year in interest income until the bonds mature in 20 years.
Once they do, the issuing corporation will redeem the bonds, paying you $10,000 to cancel the obligation
Who Should Own Bonds?
It’s generally recommended that all investors hold at least some portion of their portfolio in bonds.
Because they’re generally less volatile than stocks, bonds are a stabilizing influence in a portfolio, particularly when stock prices are falling.
Exactly what percentage of your portfolio should be in bonds depends upon several factors, including:
- Your age
- Investment time horizon (how soon will you need the money?)
- Your risk tolerance
It’s usually recommended that younger investors hold smaller positions in bonds (to maximize stock holdings) than older investors.
There are even formulas used to make this calculation.
More specifically, they determine how much of your portfolio should be invested in equities, like stocks, with the remainder held in bonds.
120 minus your age
For example, if you’re 30 years old, 90% of your portfolio should be held in equities, with the remaining 10% in bonds.
That’s because 120 minus your age (30) is 90, so 90% should be held in stocks.
If you’re 60 years old, then 60% of your portfolio should be held in stocks, and 40% in bonds. That’s because 120 minus your age (60) is 60, or 60% in stocks.
Your investment time horizon
An older investor, such as a 60-year-old, will be closer to retirement.
The need to begin withdrawing funds for living expenses is closer.
Conversely, the 30-year-old is decades away from retirement, and needs only a small allocation in bonds.
This is a variable that doesn’t have a simple formula.
It relates to the amount of risk an investor is comfortable holding in a portfolio.
High risk tolerance favors heavy investment in stocks.
A low risk tolerance favors a smaller position in stocks.
The Risks of Investing in Bonds
Though bonds are considered safer than stocks, they aren’t risk-free either. There are two primary risks with bonds:
Should the issuer fall on hard times, they may not be able to pay interest or principal on the bonds.
In a worst-case scenario, the bonds could become worthless.
This is more likely to happen with corporate bonds. Government bonds, particularly those issued by the United States Treasury, carry far less risk.
Interest rate risk
This is a risk common to all bonds, even government bonds. It works something like this:
Bond prices have an inverse relationship with interest rates. That is, when interest rates rise, bond prices fall. When interest rates fall, bond prices rise.
Obviously, the second scenario doesn’t involve risk, and even holds the possibility of capital appreciation for the bond holder. For that reason, we won’t spend any time on it.
But from a risk standpoint, rising interest rates are a real threat. This is particularly true on bonds with longer-term maturities, say 15 years or more.
Let’s say you purchase a 20-year bond with a 5% interest rate. Two years later, the prevailing rate on bonds with a similar credit rating rises to 7%. The value of the bond will fall on the bond market, to a level that will produce something approaching a 7% return.
If you purchase $10,000 in bonds at 5%, the value of the bond would have to fall to about $7,143 to support a 7% return, consistent with current bond yields. ($500 in annual interest, divided by $7,143 produces a 7% return.)
If you hold the bond until maturity, you’ll recovery your full $10,000 investment. But if you sell after two years, you’ll take a loss of nearly $3,000.
That’s what rising interest rates can do to bonds.
Different Types of Bonds
There are several major types of bonds:
These are bonds issued by corporations, typically to expand operations, pay off old debts, and sometimes for the acquisition of other companies. They generally pay higher interest than US Treasury securities, because they’re considered to be higher risk.
You can determine this risk by checking the bond rating issued by rating agencies like Moody’s or Standard & Poor’s. Bonds considered to be “investment grade” (ratings of BBB through AAA) are the least likely to default.
These are debt obligations of the US government. They can generally be purchased for as little as $100, and in the following variations:
Treasury bills. These are short-term securities, with maturities of between several days and 52 weeks. They’re sold at a discount. That means you may purchase a $100 security for $98 and redeem it for $100 at the end of the term. The difference will represent the interest paid on the security.
Treasury notes. These have maturities of two, three, five, seven and 10 years. They pay interest every six months.
Treasury bonds. These are 30-year securities that also pay interest every six months.
Treasury Inflation-Protected Securities (TIPS). These have maturities of five, 10 and 30 years, and pay interest every six months.
However, the principle is adjusted by changes in the Consumer Price Index.
A rise in the index causes the principal value of the security to increase commensurately. But the interest paid is lower than on other securities with similar terms.
EE and E Savings bonds. These are available denominations of $25.
They earn interest for 30 years and must be held for a minimum of one year.
They used to be available in paper form, but now they’re only available in electronic form.
I Savings bonds. These are savings bonds that pay interest, but also adjust for inflation, like TIPS.
These are bonds issued by states, counties and municipalities. Interest paid on municipal bonds is exempt from federal income tax.
It’s also exempt from state income tax in the state of issuance.
However, the interest is taxable if the bondholder lives in a non-issuing state.
How Can You Invest in Individual Bonds?
Virtually all types of bonds can typically be purchased and held through an investment brokerage firm.
U.S. Treasury securities can also be purchased and held through the Treasury department’s web portal, Treasury Direct.
What is a Bond Fund?
Bond funds, or bond mutual funds, are like stock funds.
They are a portfolio of bonds held in a single investment unit.
A single fund may hold hundreds of different bond issues.
The fund is run by an investment manager, who selects the best bond issues available within the investment goals of the bond fund.
Different Types of Bond Funds
Bond funds can also be segregated according to corporate bonds, municipal bonds, U.S. government securities, and even foreign bonds.
There are also high-yield bond funds, that hold lower grade bonds (rated below BBB), but pay higher interest rates.
Still, others may select bonds based on maturities.
For example, a short-term bond fund may hold a combination of securities with terms of five years or less, or longer-term securities with less than five years until maturity.
Risks of Holding Bond Funds
These are comparable to the risk of holding individual bonds in general.
That includes interest rate risk, and default risk, though to a smaller degree.
But the biggest negative with bond funds is that they often come with “load fees”.
These are fees charged for the buying and/or selling of the funds, based on a percentage of investment you make.
Load fees typically run between 1% and 3%, though some bond funds charge no load fee at all.
For example, a bond fund may charge a 3% load fee. This may be comprised of a 2% load upon purchase, and 1% on sale.
However, many mutual funds will waive the back-end load if you hold the fund for a minimum amount of time, say two or three years.
Who Should Invest in Bond Funds?
Bond funds are an excellent alternative to individual bonds for anyone who doesn’t want to get involved in the selection and management of bonds themselves.
They’re also an excellent choice for small investors, who may not be able to diversify adequately with several bond issues.
You can buy into some bond funds for as little as $1,000, which can represent 100 or more individual bonds.
How to Invest in Bonds Funds
There are various ways to invest in bond funds.
As discussed earlier, you can purchase and hold U.S. Treasury securities through TreasuryDirect.gov.
For all other bond types, including U.S. Treasuries, you can also buy and hold bonds in an investment brokerage account.
This can be either a taxable or tax-sheltered account, such as an IRA, 401(k), or some other type of retirement plan.
You can also purchase bond funds through mutual fund companies.
Main Differences Between Bonds and Bond Funds
We’ll break this down by individual categories:
Bond selection and management
With individual bonds, you must choose the bonds you will buy, then manage them in your portfolio.
A bond fund offers professional management, sparing you the investment mechanics.
A bond fund can hold hundreds of different bonds in a relatively small investment.
If you are buying individual bonds, you’ll only be able to buy as many bonds as your portfolio will allow.
Individual bonds pay interest twice annually. Bond funds pay interest monthly.
Bond funds can be quickly bought and sold, either through mutual fund families, or brokerage firms.
Though larger bond issues can be sold on secondary exchanges, smaller issues can be particularly illiquid.
Which Type of Investment Should You Hold?
If you have a large portfolio, say several hundred thousand dollars or $1 million-plus, and you have an interest in bond investing, you can construct your own bond portfolio through the purchase of individual bonds.
This is also a less expensive way to own bonds since you won’t have to pay the load fees typically charged by mutual funds.
In addition, there is less risk of loss of principal on the bonds, since you will receive 100% of your investment back when the bonds mature.
Bond funds will work better for small investors, who lack the capital to diversify.
With just a few thousand dollars, you’ll be able to invest in hundreds of bonds.
Bond funds may also work better for investors who are looking for a more frequent income stream.
Bond funds pay interest monthly, which means they can provide you with a steady monthly income.
Is One Better than the Other?
It really depends on the amount of money you have to invest, and the motivation and expertise you have with these investments.
A person with a large portfolio and specific knowledge of bond investing may be happier holding individual bonds.
A smaller investor, or one looking for steady income, will be better off the bond funds.
This will also avoid the need to spend considerable time researching individual bonds.
And unless you have expertise in bonds, the research may be only of limited value. Bond funds will be the better choice.
Other Investment Options to Consider
Whether you hold them individually or in a fund, bonds should be considered as a required portfolio holding.
You need an appropriate mix of both stocks and bonds.
Stocks provide long-term growth, while bonds provide protection of principal and steady interest income. You need both types of investments in your portfolio.
Bonds or bond funds should be held in any kind of portfolio, whether it’s a taxable account or a tax-sheltered retirement fund.
And apart from stocks and bonds, you should always have an emergency fund outside your portfolio.
This is money you can use for a short-term emergency, such as a run of expenses, or an income disruption.
The purpose of the emergency fund is to keep you from having to liquidate your investment portfolio at a bad time.
The emergency fund should be held in completely safe, liquid investments.
Consider online savings accounts, money markets, and certificates of deposit.