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Man's hand keeps dominos from fallingBonds can be useful for diversification if you’re interested in adding more stability and safety to your investment portfolio. But does it make sense to invest in bond funds, whether mutual or exchange-traded, or simply invest in individual bonds? Both can offer benefits but one may be a better fit, based on your personal investment goals, risk tolerance and individual timeline for investing. When choosing between bond funds and bonds, it’s helpful to understand how they compare.

An experienced financial advisor can help you sort through the myriad of options fixed-income investors face.

What Are Bonds and How Do They Work?

A bond is essentially a debt obligation that can be issued by a corporation or a government entity. When you invest in bonds, it’s the equivalent of making a loan to the bond issuer. And just like any loan, you benefit from your investment by earning interest. This interest is paid until the bond’s maturity date, at which point you’ll receive back the original amount you invested.

Bond prices and yields correlate to shifts in interest rates, and the two generally move in opposite directions. For example, as interest rates rise, bond prices tend to fall while bond yields increase. When interest rates are in decline, bond prices begin to rise but bond yields fall.

Bonds are typically categorized according to who issued them. So, for example, municipal bonds are bonds issued by local governments. Corporate bonds are issued by corporations. Bonds can be issued with varying maturity terms and interest rates, offering flexibility in choosing ones that meet your investment needs.

A bond is usually backed by some type of collateral or security, meaning that if the issuer defaults on interest payments, investors can still get their money back. A specific type of bond called a debenture has no collateral backing it. Instead, investors loan money based on the assumption that the bond issuer will pay it back.

Debentures are often issued by entities with strong credit ratings that have little chance of defaulting. U.S. Treasury bills,notes and bonds are debentures or unsecured bonds. You can buy these bonds directly from the Treasury and you can buy other types of bonds through an online brokerage account.

What Are Bond Funds and How Do They Work?

Anchor under a boatBond mutual funds and exchange-traded funds hold a basket of individual bond investments and are often included in portfolios as an anchor to windward, a way to hold a portfolio’s gains while it rides out a downturn in non-fixed-income securities like equities. Like other mutual funds or ETFs, bond funds have a fund manager who’s responsible for deciding which securities to include. Aside from individual bonds, bond funds can also hold certificates of deposit and other fixed-income securities. The type of bond fund can determine what kind of securities it holds. For example, you may invest in bond mutual funds that primarily hold corporate bonds. Or you may choose a bond ETF that offers exposure to municipal bonds or junk bonds. And some bond funds base their makeup on a specific maturity period, holding short-term or long-term bonds only.

Bond fund returns are not tied to a specific interest rate. Instead, bond funds generate returns based on the fund’s current net asset value or NAV. In that sense, bond funds work like any other type of mutual fund or ETF that invests in stocks and other securities. Since there’s no maturity date, you can buy or sell bond funds at any time but the return you may earn is tied to market conditions and how those affect the fund’s value.

Bond Funds vs. Bonds: Which Is Better for Investing?

Both bond funds and individual bonds can provide an additional stream of income in a portfolio, with less risk than individual stocks or stock mutual funds. When deciding whether to invest in bond funds vs. bonds, it can help to start with the pros and cons.

For example, here are some of the chief advantages of investing in bond mutual funds or ETFs:

  • Simplified diversification
  • Low barrier to entry, in terms of the minimum investment required
  • Professional fund management
  • Bond ETFs can help improve tax efficiency
  • Some bond mutual funds and ETFs carry low expense ratios

On the other hand, the biggest potential drawback of investing in bond mutual funds is the risk factor. Unlike traditional bonds, bond mutual fund returns are less predictable. That’s because they’re susceptible to fluctuations in the market that can affect their NAV. If a bond fund declines in value you could lose money if you sell it for less than what you paid for it.

In terms of what’s good about individual bonds, here are some of the main advantages:

  • Market risk is minimal when bonds are held to maturity
  • Higher-rated bonds tend to have a lower risk of default
  • Consistent income from interest, which can be paid monthly, semi-annually or annually
  • Investors can decide which bonds to invest in

Bonds do, however, have some downsides as well. For example, it’s important to understand the correlation between interest rates and bond prices and yields so you’re not buying or selling at the wrong time. If interest rates are rising, then individual bonds could be a good play, since bond prices are dropping while yields are on the rise.

You can diversify with individual bonds but the burden of choosing bonds lies with you, rather than a fund manager. That means you may need to spend time researching different bond options to decide which ones are the best fit for your portfolio. And you may need to invest larger amounts than you would with a bond fund to achieve the same level of diversification when choosing individual bonds.

How to Include Bond Funds and Bonds in a Portfolio

Government bonds Instead of choosing just bond funds vs. bonds, you could double-up and allocate a portion of your portfolio to both. You could choose an index bond fund, for example, that tracks a specific bond index and attempts to mimic its returns while also putting money into Treasury bonds or corporate bonds. This allows you to get the best of both worlds while managing risk. When deciding how much of your portfolio to allocate to bond funds vs. bonds, consider your:

  • Risk tolerance
  • Time horizon for investing
  • Amount you have to invest
  • Investment goals

If you’re in your 20s, 30s or 40s, for example, you may not be ready to devote too much of your portfolio to bonds yet. For instance, if you’re 30 and using the rule of 110 to invest for retirement, then 80% of your portfolio would theoretically be allocated to stocks with the rest to bonds. Once you settle on a percentage to allocate to bonds and bond funds, you can break it down further in deciding how much to hold of each one.

The Bottom Line

In the universe of fixed-income securities, investors have many choices. Two of the main choices are bonds funds and bonds. Each of those two has its pros and cons and, ultimately, your choice depends largely on what you need as an investor. By comparing things like how much is needed to invest, what you’ll pay to invest and the risk/reward profile of bonds and bond funds, you can better determine where to put your money.

Tips for Investing

  • If you’re considering bond funds, take time to check the expense ratios as well as the bond’s overall investment strategy. Index funds, for example, may be appealing if you’re a buy-and-hold investor who’s looking for passive income generation. With any bond mutual fund or ETF, it’s also important to check the fund manager’s track record.
  • Consider talking to a financial advisor about whether bond funds or bonds have a place in your investment strategy. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool makes it easy to find professional advisors in your local area. It takes just a few minutes to get your personalized advisor recommendations online. If you’re ready then get started now.

Photo credit: ©iStock.com/Mahmud013, ©iStock.com/ptasha, ©iStock.com/JJ Gouin

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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