BONDS ARE COMPLEX -- there's no doubt about it -- especially if you're a novice investor with little experience in the markets. That's why a lot of people opt for bond funds when they seek to diversify their investments with some fixed-income exposure. Our view is that if you're willing to put in the effort, you're better off buying individual bonds instead of bond funds. But in the real world, a fund is sometimes worth the convenience.
Here's what you have to consider:
Like an equity mutual fund, a bond fund is managed by a professional investor who buys a portfolio of securities and makes all the decisions. Most funds buy bonds of a specific type, maturity and risk profile -- 15 year corporates, for instance, or tax-free 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 triple-tax-free New York City 30-year bonds, you may be better off going the easy route and picking a good fund.
The disadvantage of a bond fund is that it's not a bond. It has neither a fixed yield nor a contractual obligation to give investors back their principal at some later maturity date -- the two key characteristics of individual bonds. Then there are the fees and expenses that can cut into returns. Finally, because fund managers constantly trade their positions, the risk-return profile of a bond-fund investment is continually changing: Unlike an actual bond, whose risk level declines the longer it is held by an investor, a fund can increase or decrease its risk exposure at the whim of the manager.
The other thing about building your own portfolio of bonds is that you can tailor it to meet your circumstances, meaning the bonds will mature precisely when you need them. A bond fund cannot deliver that sort of precision.
Our advice is this: If you lack the time or interest to manage a bond portfolio on your own -- or if you want a mixed portfolio of corporates or municipals -- buy a bond fund. But if you want a tailored portfolio of Treasurys to mature when your kid goes to college -- and you want to avoid the fees and added risk associated with bond funds -- go ahead and take the plunge.