July 27, 2008

Bonds 101, part 5 - Bonds versus Bond funds

I've been discussing bonds as individual investments. Buying individual bonds is much like buying individual stocks. With individual bonds or stocks your money is dependent on specific companies or institutions. If all your money is in a single bond or stock at that bond or stock fails then your money is in jeopardy. For this reason it is always good to spread your money around and diversify your investment.

Bond funds offer a simple and easy way to invest in bonds and diversify your investment. Bond funds are managed mutual fund that invests in bonds. A bond fund will be a managed fund that is invested in a variety of bonds in a certain class.

Here are some pros and cons for bond funds:

Easy : buy a single fund easily
Diversified : you don't carry the risk of your individual bonds defaulting
Liquidity : funds can be sold fast and easily
Lower minimums : you can start investing in bond funds with a lower minimum cost

Variable returns : the yield for a bond fund will go up and down as the fund changes its bond investments
Variable price : the price you can sell the fund for will change over time as the fund does better or poorer and as the economy as a whole reflects on bond values
Management expenses : bond funds carry expenses usually around 0.75%, which is substantial expense relative to bond yields
Capital gains : a bond fund could be liable for capital gains taxes

In general the key benefit of a bond fund is the diversification and ease of investing. If you have a smaller amount to invest and don't have the time or knowledge to delve into individual bonds then a bond fund might be an OK choice. On the other hand individual bonds will give you better return and have lower expenses. So if you have enough funds to diversify your bonds and can take the time and effort to fully understand what you're investing in then individual bonds are going to be the better option.

Treasuries are a separate case. Treasuries carry virtually no risk of default and are relatively easy to understand and invest in. Therefore a treasury bond fund makes little sense compared to investing directly in individual treasuries.

Additional articles on the topic:

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