Investing in bonds and investing in bond funds (including ETFs) are not the same. Let’s break down some key differences between the two that you might not be aware of.
Choosing a bond versus choosing a fund
With a bond fund, the investor chooses which vehicle to buy; it can be actively or passively managed. This purchase requires less time and research expertise than choosing individual bonds, although investors do have a plethora of fund choices, including bond index funds.
With individual bonds, an investor (or advisor) selects the bond(s), but options will be rather limited for the average investor. Minimum investments for single bonds can be quite high, which limits the ability to diversify. To access a variety of attractive bonds at favourable pricing, you need a lot more money than is required to access most bond mutual funds and fixed income ETFs.
With bond funds, the actions of other investors will affect the fund’s performance. When unitholders decide to sell — for whatever reason — the portfolio manager (PM) must deliver the funds on a pre-established timeline, regardless of market conditions.
Sometimes this requires the sale of a bond to raise sufficient funds. The PM wants to execute the best trade, but if bonds are having a bad run and someone gets nervous or simply needs money, the PM could be forced to sell at a loss. And that loss is passed on to all unitholders, not just those who needed liquidity and redeemed.
Meanwhile, individual bonds can be held until maturity if the investor decides to do so and doesn’t have any interim cash flow needs. The investor purchases the bond, collects the coupon payments, and at maturity receives the face value of the bond. The investor is unaffected by moves in market interest rates as long as they don’t sell the bond. The price of the bond will fluctuate, but this doesn’t matter if he or she eventually receives face value.
Interest payments versus distributions
With bond mutual funds or ETFs, the investor indirectly receives the interest paid by the underlying bonds in the fund by way of distributions.
With individual bonds, the investor receives coupon interest payments directly from the issuer.
MERs versus trading costs
The cost of owning a bond fund is largely determined by the MER, or management expense ratio. This is made up of the management fee paid to those running the fund, a trailer fee paid to advisors who recommend the fund, and operating expenses such as legal and administration costs.
The cost to invest in individual bonds will vary based on the transaction fees and pricing available to investors and their brokerage firms. Smaller transactions will typically receive less favourable pricing and trading costs — something to consider when evaluating bonds versus bond funds.
Can bonds lose money?
While bonds are considered safer than stocks, investors can lose money with bonds and bond funds. Bond prices will decline when interest rates rise; when the issuer experiences a negative credit event such as a default, restructuring or bankruptcy; or in a liquidity crunch.
Bond fund investors face greater risk — interest rate risk, specifically — since they are exposed to falling prices when interest rates rise. Whereas direct investors in bonds can ride out rising interest rates until their bonds mature.
It’s not all bad news though, as fund investors benefit from lower interest rates that boost bond prices. But investors who own bonds directly will benefit from rising prices only if they can sell their bond to another investor prior to maturity and for a price above what they paid for it.
Those who are not high-net-worth investors have limited ability to invest directly in bonds. And there is limited rationale to do so based on pricing issues and the difficulty of achieving adequate diversification.
For those who have a choice, there are tradeoffs to consider, such as MERs and lack of control over the underlying investments that are part and parcel of investing in a fund.
Some investors may benefit more from investing in individual bonds while others will do better with a bond fund or might only have access to funds.
Where possible, investors could combine bond funds and individual bonds so that their portfolio is better insulated from various market and/or economic effects.
The key is knowing and understanding the important differences when deciding whether to invest in a bond or bond fund.