Choosing Between Bonds and Bond Funds
Bonds play a role in a portfolio, even when the outlook for interest rates is uncertain. They offer a lower level of volatility than stocks. Plus, bonds have historically had different return characteristics. Determining how to best get exposure to them can be a challenge, however, as there are advantages and disadvantages to choosing between bond funds and individual bonds.
Bond funds offer ease and simplicity. A bond fund gives you instant access to a diversified portfolio of bond holdings. The downside is that the typical bond fund, unlike an actual bond, never matures. The price of a fund’s shares and the cash flows you receive will depend on the bond market’s fluctuations—which are influenced by changes in interest rates—and, of course, the manager’s skill. So, bond funds lack a guaranteed rate of return. Furthermore, with a bond fund you will pay ongoing annual management expenses and have no ability to control the timing of capital gains.
Bonds offer a higher (but not absolute) level of predictability. A bond held to maturity will provide a fixed rate of return. At a pre-specified date, you will get the face (“par”) value of the bond back, typically $1,000 per bond. In addition, you will receive semiannual interest (“coupon”) payments. Both of these amounts are fixed for traditional American bonds and enable you to calculate the pretax rate of return at the time of purchase. This rate of return does not alter as long as you keep the bond to maturity. This is why some bond experts suggest buying actual bonds as opposed to bond funds.
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