The current shift towards higher interest rates has sparked a renewed conversation on whether regular investors should lean towards individual bonds or bond mutual funds. Back when interest rates were close to zero for an extended period, mutual funds were a popular choice. They came with low fees, were easy to buy and sell, and their share values tended to rise with bond prices. However, recent events, where major bond funds saw significant declines, have made investors rethink this approach.
Consequently, now many are considering the option of purchasing individual bonds and holding onto them until they mature. The idea here is to safeguard an initial investment by locking in today’s higher interest rates. Nonetheless, it is important to remark that although individual bonds offer the advantage of capital protection, there is a catch as if the company you lent money to runs into trouble and defaults on its debt, you might face substantial losses too.
On the flip side, bond funds spread their investments across a variety of bonds, minimizing the impact of any single default. However, the value of these funds can fluctuate with changes in interest rates.
Moreover, it is important to know that deciding between individual bonds and funds involves considering factors like capital protection, ease of trading, and the impact of rising interest rates. For instance, buying individual bonds requires more effort, involving research and ongoing management, possibly even the assistance of financial advisers, while bond funds are more accessible, popular among investors, and offer diversification to mitigate risks. In addition, understanding the difference between a bond’s coupon (fixed interest payment) and yield (actual return factoring in the bond’s price) is crucial as bonds bought directly need constant monitoring, while fund investors receive regular yields through dividend payments. Furthermore, tax implications also come into play, with municipal bonds and funds often providing tax advantages. Residents of smaller states might find it easier to manage state-specific portfolios by directly buying bonds. Investors holding bonds also have the flexibility to strategically sell them to offset gains—a technique known as “tax-loss harvesting.”
Ultimately, the decision between individual bonds and funds is a strategic choice that should align with an investor’s unique combination of risk tolerance, investment objectives, and the ever-changing financial landscape, and for those still undecided, there are hybrid options like ETFs with set maturity dates or separately managed accounts.
