Investors are pouring billions into bonds by way of bond funds to earn higher interest rates. Bond funds are an investor favorite because they offer the average investor advantages vs. buying individual bond issues. But these funds have their disadvantages as well. Let’s look at bond funds vs. bonds.
Millions of everyday people own bond funds because they are easy to invest in and they pay higher interest or dividends then they can get at the bank. When you invest money in a bond fund you own part of a professionally managed portfolio of these securities. That diversification decreases your credit risk or risk of default because your money is spread around.
In fact, without bond funds many average investors would probably not invest in bonds. First, these funds are often SOLD to investors looking for higher income by financial planners and other investment representatives. Second, most people are intimidated by the prospect of selecting and investing in individual bond issues. Bond features can be difficult to understand. Why take the risk of making a mistake and picking a loser?
The most obvious disadvantage of bond funds is that many of them sold to investors have a sales charge and relatively high yearly expenses. It doesn’t make sense to pay 4% off the top and more than 1% a year for expenses. Individual bonds can be purchased much cheaper. For the average investor funds make sense IF they are no-load funds (no sales charges) with low yearly expenses of ½% or less.
There’s one more disadvantage to bond funds vs. bonds you rarely hear about. When you hold an individual bond you know exactly what you will make each year in interest; and you know that when your bond matures you will get your principal back (unless the issuer defaults). For example, if you buy a $1000 bond with a 6% coupon rate that matures in ten years: you will earn $60 a year in interest and get $1000 back in ten years.
Bond funds do not mature. On an ongoing basis they take in money from investors, redeem shares for existing investors, and buy and sell bonds in their portfolio. Let’s look at a possible scenario most bond investors would rather not think about.
You invest in a bond fund with an average maturity of 10 years when interest rates are real low, and 10-year bonds of the highest quality are yielding about 4% or so. You elect to have your interest in the form of dividends sent to you as income. Interest rates then go up, as bond prices fall (as would be the case). Rates continue to go up and the highest quality 10-year bonds are now yielding 8% six or seven years later. The value of your bond fund is down considerably.
Had you invested in 10-year individual $1000 bonds instead of a fund, your investment would have dropped in value as well… with one difference. After six or seven years you would have something to look forward to. The value of your bonds would eventually rise to $1000 as their maturity date drew near… no matter what happens to interest rates.
As a holder of a bond fund in the above scenario there is no maturity date to look forward to that can bail you out without a loss of principal.
A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.
Jim is the author of a complete investor guide, Invest Informed, designed for average investors or would-be investors of all levels of financial background and experience. To learn more about investments and investing and his new financial guide go to http://www.investinformed.com.