Bonds versus Bond Funds

Individual bonds and bond funds are two very different animals. Understanding how bond funds and individual bonds differ will help you assess which is the best investment option for you. Here are four factors you should consider:

1. Return of Principal. Unless there is a default, when an individual bond matures or is called, your principal is returned. That is not true with bond funds. Bond funds have no obligation to return your principal. Except for UITs, they have no maturity date. With a bond fund, the value of your investment fluctuates from day to day. While this is also true of individual bonds trading in the secondary market, if the price of a bond declines below par, you always have the option of holding the bond until it matures and collecting the principal.
   
   
2. Income. With most fixed-rate individual bonds, you know exactly how much interest you'll receive. With bond funds, the interest you receive can fluctuate with changes to the underlying bond portfolio. Another consideration is that many bond funds pay interest monthly opposed to semiannually, as is the case with most individual bonds.
   
   
3. Diversification. With a single purchase, a bond fund provides you with instant diversification at a very low cost. To put together a diversified portfolio of individual bonds, you'll need to purchase several bonds, and that might cost you $50,000 or more. Most mutual funds only require a minimum investment of a few thousand dollars.
   
   
4. Liquidity. Virtually all bond funds can be sold easily at anytime at the current fund value (NAV). The liquidity of individual bonds, on the other hand, can vary considerably depending on the bond. In addition to taking longer to sell, illiquid bonds may also be more expensive to sell.
   
   

Comparing Bonds and Bond Funds

	Individual Bonds	Bond Mutual Funds	Closed-End Bond Funds	Bond UITs	Bond ETFs
Return of Principal	Principal returned at maturity or when bond is called	Principal at risk	Principal at risk	Receive principal back as bonds in UIT mature or are called	Principal at risk
Maturity Date	Set maturity date	None	None	UIT liquidated on set date	None
Income Payments	Usually fixed and paid semiannually (except zero-coupon bonds)	Fluctuating monthly payments	Fluctuating monthly or quarterly payments	Fixed monthly, quarterly, or semiannual payments	Fluctuating monthly payments
Liquidity	Trade on secondary market above or below their face value, but some bonds can be hard to sell	Bought and sold at net asset value	Trade on an exchange with daily fluctuation in the unit price	Bought and sold at NAV	Trade on an exchange with daily fluctuation in the unit price
Redeemable	Redeemable only at maturity or when called	By selling shares at prevailing NAV	By selling shares at prevailing unit price	By selling shares at NAV	By selling shares at prevailing unit price
Default Risk	Varies by credit quality of bond	Limited by diversification	Limited by diversification	Limited by diversification	Limited by diversification
Interest Rate Risk	Exists but declines as bonds near maturity	Exists and sensitivity to interest rates depends on portfolio of holdings	Because some closed-end funds are highly leveraged, they can be very sensitive to interest rate increases	Exists and sensitivity to interest rates depends on portfolio of holdings	Exists and sensitivity to interest rates depends on portfolio of holdings
Expenses	No ongoing expenses; transaction charge built into price for purchases and sales	Annual fees; may have front- or back-end sales charge	Annual fees and brokerage commissions	Annual fees (usually lower than mutual fund fees) and front-end sales charge	Annual fees (usually lower than mutual fund fees) and brokerage commissions
Reinvestment	No automatic reinvestment option	Automatic reinvestment option	Automatic reinvestment option	Automatic reinvestment option	Automatic reinvestment option available for most but not all ETFs
Professionally Managed	No management	Actively managed (except index funds)	Actively managed	Passively managed	Most are passively managed; some are now actively managed.
Diversification	Need to purchase multiple bonds to diversify	Constantly changing portfolio of bonds	Constantly changing portfolio of bonds	Fixed portfolio of bonds; less diversified than many bond mutual funds, closed-end funds or ETFs	Constantly changing portfolio of bonds