Individual bonds and bond funds are two very different animals. Understanding how bond funds and individual bonds differ will help you assess which is the best investment option for you. Here are four factors you should consider:

1. Return of Principal. Unless there is a default, when an individual bond matures or is called, your principal is returned. That is not true with bond funds. Bond funds have no obligation to return your principal. Except for UITs, they have no maturity date. With a bond fund, the value of your investment fluctuates from day to day. While this is also true of individual bonds trading in the secondary market, if the price of a bond declines below par, you always have the option of holding the bond until it matures and collecting the principal.

2. Income. With most fixed-rate individual bonds, you know exactly how much interest you’ll receive. With bond funds, the interest you receive can fluctuate with changes to the underlying bond portfolio. Another consideration is that many bond funds pay interest monthly opposed to semiannually, as is the case with most individual bonds.

3. Diversification. With a single purchase, a bond fund provides you with instant diversification at a very low cost. To put together a diversified portfolio of individual bonds, you’ll need to purchase several bonds, and that might cost you $50,000 or more. Most mutual funds only require a minimum investment of a few thousand dollars.

4. Liquidity. Virtually all bond funds can be sold easily at anytime at the current fund value (NAV). The liquidity of individual bonds, on the other hand, can vary considerably depending on the bond. In addition to taking longer to sell, illiquid bonds may also be more expensive to sell.

Things to consider

Like an equity mutual fund, a bond fund is managed by a professional money manager who buys a portfolio of securities and makes all the decisions. Most funds buy bonds of a specific type, maturity and risk profile — long-term corporates, for instance, or taxfree municipals — and pay out a coupon to investors — often monthly, rather than annually or semiannually like a regular bond. The chief advantage of a bond fund is that it’s convenient. It’s also true that when it comes to buying corporate and municipal bonds, a professional manager backed by a strong research organization can make better decisions than the average individual investor. Consequently, if you want to dabble in junk bonds or shelter your income with high-yield muni bonds, you may be better off going the easy route and picking a good fund. The MF companies can often buy bonds that are odd lots yet attractive that the individual investor cannot buy.

The cash outlay required to build an INDIVIDUAL bond portfolio could be another reason why a bond fund might make more sense. Bonds —especially municipals — typically sell in $25,000 lots to individual investors. And while you can find a few offerings in the $10,000 or even $5,000 range, you won’t have as much selection. So if an investor doesn’t have enough to comfortably meet the high minimums associated with building a diversified bond portfolio, bond funds are a good alternative. These funds typically have minimum investment requirements of just $1,000.

The disadvantage of a bond fund is that it’s not a bond. It has neither a fixed yield nor a maturity date — the two key characteristics of individual bonds. The expenses that can cut into returns. Although it can be very expensive to buy an individual bond portfolio when you add up transaction costs. In sum, you get professional research and management and easy diversification with a fund. You can also reinvest bond payouts automatically —something you can’t do with individual bonds. Lastly, it’s easier to sell shares of bond funds than individual bonds as you can sell the MF at NAV any day. Some bonds are not very liquid and if you sell it you may not get the best price. An individual bond portfolio makes the most sense when somebody has $50K+ to invest and they want to build a customized, laddered bond portfolio.

Let us help you set up a Bond Portfolio

As independent investment advisors we feel that all of our clients are entitled to customized advice, tailored specifically to their individual situations, investing goals and risk tolerances. One of the benefits of being independent is that we are free to consider among the thousands of investment alternatives available. We weigh the merits of each investment recommending investments only because they will contribute to the success of your investment strategy. There is no pressure, and no incentive, to sell you proprietary products. We then help you track the progress of your portfolio toward the financial goals you’ve set, and advise you when it is appropriate to make changes and when it’s time to stand pat.

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