Wednesday, March 18, 2009

Great Debate: Bonds vs. Bond Funds

Ladies and Gentlemen, financial fight enthusiasts of all ages, welcome to tonight's event. We are moments away from our main event, a bout that will go down in history and settle one of the great debates in finance once and for all, the argument over whether buying individual bonds or bond mutual funds is the best way to get some bond exposure.

As you are well aware, this grudge match has gotten especially dirty, since both the fighters fill the bond part of your asset allocation. This means they're government or corporate debt, and pay out higher interest rates than most stocks. They also tend to be more stable in price than stocks; they don't drop as far in value, but they also don't rise as fast. Finally, there's more protection if the company or government goes bankrupt than you have with stocks. But that's where the similarities end.

Wait, wait, the fighters are entering the ring. They're circling each other, eyeing each other up. And individuals bonds make the first move, pummeling bond funds with all their advantages:

Fixed Interest Rates: The biggest advantage of individual bonds is that the interest rates they offer stay the same for the life of the bond. (Unless it's called or the company defaults; although those are fairly rare events, especially with high quality bonds.) If you lock in a high interest rate for a long-term bond, you can enjoy high dividend payments for years, decades even.

Return of principal: When the bond's term is up, you're guaranteed to get back your principal. The amount for which you can sell the bonds before they reach maturity can vary, but the underlying principal will be returned at maturity (again, barring defaults). With bond funds, the amount of principal will move up and down as the share prices change.

Oh, bond funds have been taking a beating! But wait, here they come, bringing out all the pluses that come with funds:

Easy Diversification: The biggest advantage of bond funds is the ability to own hundreds, if not thousands of bonds with one investment. The natural diversification of funds lowers the cost to add bonds to your portfolio, as well as decrease the risk should any of the bonds in the fund default.

It's one heck of a struggle out there! And here come the ref, making a ruling on the mat. And it's a tie! Depending on the situation it seems that either individual bonds or funds could be a good choice for the fixed income portion of your portfolio.

There are a few caveats, though; the higher the risk of default, the more advantageous it is to opt for bond mutual funds. If you decide to dabble in junk bonds, for example, you'll end up much better financially by using a high-yield bond fund. The large number of bonds held by the fund will insulate you from much of the risk of default, allowing you to profit from the higher yield of these bonds without gambling on your portfolio.

On the other end of the risk spectrum, if you're looking to invest in Treasuries (US government bonds), you would do best by buying directly from the Treasury. There's essentially no default risk, the bonds are never called, and you can avoid the fees that mutual funds charge by buying Treasuries yourself.

For high grade corporate bonds, which have a moderate amount of risk, you could go either way. If you have the money to create a diverse portfolio and like the characteristics of individual bonds, go ahead with the bonds; if not, bond mutual funds will do fine.

Oh, ladies and gentlemen, that was certainly a thrilling debate. I think we've all gained a little more knowledge about bonds and bond funds.

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