One of the more frequent questions we hear pertains to investing in fixed income mutual funds vs. buying individual bonds. The question usually takes the form of something like “Why invest in a bond fund when you can buy individual bond(s), collect the coupons, and hold until maturity?” The underlying assumption in the question is, of course, that if you just hold until maturity, you are guaranteed to get your principal back, whereas with a bond fund, you risk a loss of principal.
To check on that assumption, let’s consider one of the primary drivers of bond fund losses – a rise in interest rates. As a reminder, bond prices are inversely correlated with interest rates, which means that when rates rise, bond prices fall and vice-versa. This is true for individual [fixed-coupon] bonds and bond mutual funds alike. The only real difference is transparency. Bond funds are required to calculate a fair value price on all holdings on a daily basis, so losses due to a rise in interest rates are readily apparent in the reported daily NAV (Net Asset Value) i.e. price of the fund.
For an individual bond investment, the loss is not as obvious, so perhaps it doesn’t sting as much. But to be clear, if you hold an individual bond and interest rates surge, your investment has lost value as well. The difference is that individual bond prices are not normally quoted in the newspaper so it would take a phone call to a bond broker to get this information. So while it may be easier to ignore the paper losses on an individual bond in a rising rate environment, this turns out to be a bit like turning up the radio in your car to cover up the sound of the engine knocking!
Beyond enhanced transparency, bond mutual funds have other distinct advantages over individual bond investments. Most importantly, a bond mutual fund is diversified, likely holding hundreds of individual bonds in the portfolio and vastly reducing the risk of truly catastrophic losses. The holder of an individual bond has no such protection in case of a default.
Secondly, bond funds are, on average, far more liquid than an individual bond. High liquidity is desirable, and means that you can sell your bond fund investment quickly and easily at the prevailing market price. In contrast, if you needed to sell an individual bond before maturity for whatever reason, you would have to go to a bond broker to make the sale. Depending on the characteristics of the bond itself, you may need to accept a substantial price discount to get the bond sold quickly.
Another advantage that bond funds have is the option to automatically reinvest your interest income. This is especially beneficial in a rising rate environment as each successive coupon payment gets reinvested at higher interest rates, improving long-term returns.
Finally, a bond mutual fund can maintain a constant exposure to interest rate risk, by keeping the weighted average maturity of the portfolio constant. The average maturity (and credit risk) is disclosed in the fund’s prospectus and is relatively easy to look up. In this sense, bond fund investors have a very clear sense of the risk(s) they are taking. You could achieve a similar result with individual bonds, but it would require some research and quite a bit of buying and selling, not to mention some complicated math calculations.
The main disadvantage of a bond mutual fund is the lack of a stable, predictable coupon payment. Bond fund income distributions will fluctuate over time as interest rates change and holdings are turned over in the portfolio. But for most investors who don’t require that level of predictability, a well-diversified bond fund likely provides the most attractive combination of attributes.