I hope that this post helps to clarify the difference between purchasing a bond fund, and an individual bond outright. For the purpose of this post, we will assume that the type of bond we are dealing with are U.S. Treasuries.
Individual Bonds 1. An important reason one would buy an individual bond is to guarantee their principal amount being preserved (by holding until maturity). For example if one has $5000 and they wish to still have $5000 by 1 year from now, they might buy a bond with a 1% yield and maturity date of 1 year later. This would mean that by the time the bond matures 1 year later, they would have received $50 plus their entire $5000 principal back, guaranteed (we are assuming treasuries). It is important to note that the principal is preserved because the holder only redeemed at the maturity date. Between purchase and maturity date, the value of the bond fluctuates, but as long as the holder holds until the maturity date they will get the full principal back.
- Worst case scenario for individual bonds (treasuries that is) is if you have to sell the bond early at a loss. As noted above, the value of the bond is guaranteed if you hold until maturity, but if you need the money before the maturity date, then you’d be at the mercy of the market price at that time.
Bond funds In comparison to individual bonds, the principal is not guaranteed because there is no maturity date. This is evidently seen if you look at the graph of VBMFX (http://ift.tt/1tnwssM) and simply notice that the value does decline. (Thus if you had unfortunately purchased at the peak and were planning to redeem when the total value was lower, then you would have to redeem at a loss) However, in almost every other scenario aside from requiring the full principal at a later date, the bond fund has unique and strong things going for it.
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Let’s assume that interest rates have went up, causing the value of the bond fund to go down. Even in this seemingly bad scenario (our assets lost value!) it really isn’t so bad. In the long term, it is likely that the value of the fund will come back. This is because of a couple of reasons: the coupons of the bonds are reinvested into bonds with the current higher yield. Furthermore, each bond that matures will be reinvested into bonds with the current higher yield. The net result is that over time the bond fund (quite quickly actually) grows into the new higher rate environment, and the NAV rebounds.
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It allows for easy diversification. A bond fund allows you to diversify in many ways, not but limited to: maturity, yield, type of bond. Thus for example, one fund might have a 4% treasury bond with maturity date 6 years from now, a 1% municipal bond with maturity date 1 year from now, and a 6% corporate bond with maturity date 30 years from now. This way you can take a balance between duration sensitivity and higher yield.
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It’s easy to buy and manage. While it isn’t very hard to buy an individual bond, there is definitely more process to it than buying a bond fund (it can be bought as a mutual fund or ETF just like stocks). And as for management - you do not really need to do anything! Someone else will manage the fund for a low expense ratio (like VBMFX noted above) which for example involves purchasing new bonds continually over time.
4 . Worst case scenario for bond funds is if the fund (the fund manager) is forced to liquidate their individual funds at lower market prices (perhaps due to many investors selling the fund). The reason this is bad is that they would not be able to reinvest the coupons and matured bonds as seen in point #1, but would instead have to take a loss as seen in the worst case for individual bonds.
Conclusion and observations If you have plans where you need to have EXACTLY a certain amount of money in the future, there is a certain level of risk that this may not be guaranteed with a bond fund and thus you may wish to invest in individual bonds instead. Even if the risk is small, small risk is nonzero risk.
On the other hand, if you do not have a specific date of redemption in mind and am maybe just investing generally for the long term, then bond funds make a lot of sense
Source “The Bond Book, Third Edition: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More” by Annette Thau (A great read by the way, you can simply flip to the type of bond you wish to learn more about, but that’s a different post)
I hope this helped to clarify when to buy a bond vs a bond fund. Feel free to leave comments or questions below!
Submitted January 19, 2017 at 12:16AM by jjstock http://ift.tt/2iDUqFM
