Bond Funds: Worth The Investment Risk?

Investing in bond funds is a topic that has gained traction in recent years, especially with the rise of interest rates. The decision to invest in bond funds depends on several factors, including an individual's financial goals, risk tolerance, and time horizon. Bond funds offer greater diversification and access to institutional pricing, but they also come with management fees and fluctuating net asset values. On the other hand, individual bonds provide a predictable income stream, a predictable value at maturity, and a personal cost basis. However, they require significant time and resources for research and management.

Individual bonds vs bond funds

There are several factors to consider when deciding between investing in individual bonds or bond funds. These include diversification, convenience, costs, and control over maturity. While some believe that owning individual bonds is less risky, this is not necessarily true if an appropriate bond fund or collection of funds is chosen.

Advantages of Individual Bonds

• Reliable income stream: Individual bonds typically pay semi-annual coupon or interest payments, providing a predictable income stream for investors.
• Predictable value at maturity: Individual bonds have a fixed principal value, also known as the face or par value, that is repaid at maturity, barring any default by the issuer.
• Customisation: Investors can build a bond portfolio that suits their specific investment objectives and risk tolerance.
• Superior financial disclosures: Corporate bond issuers provide quarterly financial statements, enabling investors to assess the financial health of the issuing company.
• Ease of buying and selling: The corporate bond market is dynamic, and individual bond trades can be executed quickly, allowing investors to act swiftly in response to market events.
• Knowledge of investment: With individual bonds, investors know exactly what they are investing in, including the issuer, yield, maturity date, price, and credit spread.
• Return of principal: Individual bonds are required to repay investors the face value at maturity, providing a level of certainty and security.

Disadvantages of Individual Bonds

• Diversification: Achieving diversification with individual bonds may be challenging and cost-prohibitive, as a large number of bonds across different sub-asset classes and issuers are needed.
• Pricing: Individual investors may receive less attractive pricing compared to institutional investors who purchase large quantities of bonds.
• Time and research: Researching and managing a strategy for individual bonds can be time-consuming, given the vast number of issuers and bonds available.

Advantages of Bond Funds

• Diversification: Bond funds provide greater diversification per dollar invested, as they hold a large number of bonds with varying maturity dates, coupon rates, and credit ratings.
• Institutional pricing: Bond funds often receive better pricing on individual bonds compared to individual investors, resulting in higher yields.
• Professional management: Actively managed bond funds can navigate riskier segments of the fixed income market and adjust their bond holdings based on economic conditions and interest rates.

Disadvantages of Bond Funds

• Management fees: Actively managed bond funds may have higher management fees, potentially leading to lower returns.
• Net asset value (NAV) fluctuations: The NAV of bond funds fluctuates with interest rates, making it challenging to predict future values and plan for specific liabilities.
• Cost basis and tax consequences: Pooled funds in bond funds result in a more complex cost basis for tax purposes, and capital gain distributions may be difficult to anticipate.

Pros and cons of bond funds

Pros of Bond Funds

• Greater diversification per dollar invested: It is much easier to achieve a diversified bond portfolio per dollar invested using a fund because you obtain exposure to a basket of bonds within the fund.
• Access to institutional pricing: Bond funds generally receive better pricing on individual bonds than individual investors do. All else being equal, a lower price means a higher yield.
• Professional management: Some of the riskier segments of the fixed-income market, like high-yield bonds, bank loans, or preferred securities, have many nuances and require a good knowledge of industry trends and credit analysis to navigate them successfully. If the fund is more actively managed, it also allows for the manager to buy or sell bonds depending on the economic and interest rate environment, potentially increasing returns and income.

Cons of Bond Funds

• Management fee: Management fees for the more actively traded bond funds can be higher, which may lead to lower returns. In contrast, when owning individual bonds, there's usually a commission charged when the bond is purchased, and unless it's sold prior to maturity, there are no other charges.
• Net asset value (NAV) will fluctuate with the market: As interest rates rise and fall, the NAV of a given bond fund will fall and rise respectively, and there's no certainty as to what the NAV may be at a point in the future. This makes bond funds less attractive than individual bonds when planning for future liabilities.
• Different cost basis and tax consequences: Bond funds pool money in order to purchase the bonds in the portfolio. With pooled funds, your cost basis for tax purposes won't be as simple as if you had purchased an individual bond and held it to maturity. Additionally, you do not have control of the buying and selling of the individual bonds, which can lead to capital gain distributions at the end of the year. These capital gain distributions can be hard to anticipate and plan for from a tax standpoint.

High-quality bonds

There are a few things to consider when investing in high-quality bonds. Firstly, the required research and oversight may be more extensive than with other investments. To assemble a diversified portfolio, you may need to invest in a broad range of different bonds from different issuers. This will generally involve researching and monitoring the financial stability of each issuer, determining if the bond's price is reasonable, and building a portfolio that aligns with your income needs, risk tolerance, and diversification goals.

Secondly, investing in individual bonds typically requires a higher initial investment amount compared to bond funds. Bonds usually trade with a minimum order quantity, and assembling a diversified portfolio entails buying bonds from many different issuers.

Lastly, the impact of rising or falling interest rates on individual bonds may be lower than on bond funds. When interest rates rise, the market value of bonds generally falls, and when interest rates fall, bond prices rise. However, investors who hold individual bonds until maturity may not realize this impact.

In summary, high-quality bonds can be a great addition to your portfolio, providing diversification and predictable income. However, they require careful research and a higher initial investment amount. The impact of interest rates on individual bonds may be lower than on bond funds, but holding bonds until maturity can mitigate this effect.

Bond yields

The yield on a bond is the return you will make on it. It is made up of the interest you are paid and any capital gain or loss you make when you sell the bond. Bond prices and yields move in opposite directions: when yields go up, prices go down, and vice versa.

When you buy a bond, you are effectively lending money to the borrower (known as the issuer), who will pay you back the face value of the bond when it matures. In the meantime, they will pay you interest at regular intervals. The interest rate is set when the bond is issued, so the yield you will get from interest is known upfront. However, the capital gain or loss you will make depends on the price you sell the bond for, which may be higher or lower than the face value.

If interest rates go up after you have bought a bond, new bonds will be issued with higher interest rates. This means that your bond is less desirable, so its price will fall. The buyer is compensated for the lower price by getting a higher yield.

However, it is impossible to predict exactly when interest rates will change. While yields may be appealing now, they may be even better in future. Therefore, it is generally recommended to buy bonds and hold them until maturity, rather than trying to time the market.

You can buy individual bonds or invest in a bond fund. Individual bonds give you more control over what is in your portfolio, but require more time and money to build a diversified portfolio. Bond funds are managed for you and are an easier way to achieve diversification with a smaller initial investment, but you have less control over what is in your portfolio.

Interest rates

The relationship between interest rates and bond prices is inverse: when interest rates rise, bond prices fall, and vice versa. This is because the market value of individual bonds is based on the prevailing level of interest rates. So, when interest rates rise, the market value of individual bonds falls, and investors who hold individual bonds to maturity will not realise this impact. On the other hand, investors in bond funds may be more likely to experience volatility in the performance of their investment when interest rates rise or fall.

In a high-interest-rate environment, some investors may be reluctant to hold bonds. However, high-quality bonds can still be appealing to investors due to the coupon income they provide, which is predictable and consistent without the price volatility of riskier assets.

When interest rates are low, bonds are less appealing as an investment. This is because the opportunity cost of holding a bond to maturity is higher when an investor could be taking advantage of the higher coupons offered by newer bonds on the market.

Predicting the path of interest rates is challenging, and it is impossible to time the market perfectly. However, some investors may try to take advantage of an investment opportunity in bonds when interest rates are high and expected to decrease.

In summary, the decision to invest in bonds and the amount to invest will depend on each individual investor's circumstances, including their risk tolerance, financial goals, and time horizon.

Frequently asked questions