Direct bond investing compared to their cousin the bond fund

When the decision to invest in fixed income assets is made should you buy individual bonds or purchase a fund that invests in bonds? In a series of articles, we compare bonds to other options. Today, we compare bonds to its cousin the bond fund.

The standout attraction of direct bond investing is knowledge of receiving a defined amount of income at regular intervals. This income is expressed through a coupon. The bond’s principal is then returned when the bond matures.

When you buy a direct bond you lockin the rate of return that is fixed at the time of purchase. This total rate of return is known as the yield to maturity. As the future cash flows are known – there are the regular coupons to be paid and an amount at maturity – the total return can be seen.

Yield to maturity can also be seen as the annual return on your initial investment through to some predetermined future date.

There are two assumptions to achieving this fixed return. One, you hold the bond until maturity (or it is called) and secondly, the issuer does not default.

In a bond fund you hold units in a pool with other investors. A fund manager then allocates to the securities they feel best achieves the investment objective of the fund. Bond funds invest in many different securities, so it’s an easier way to achieve diversification even with a small investment.

The value of bonds held are then priced to the market and a price for your basket of bonds is produced, this is known as the unit price. A fund manager rarely holds bonds to maturity instead they mix them to create a pool of assets with different income dates and amounts. The incomes are then added together and occasionally sent to the investor as dividends. The dividends can change. For investor’s wanting line of sight of their cashflows, bond funds can be less attractive.

With a bond fund when you sell you receive the current value of the securities as reflected in the market. This means that the value of the bond fund could be higher or lower than the initial purchase cost.

All investor circumstances are different but here are some of the advantages and drawbacks of bond funds compared to direct bond investing.

The benefits of investing in bond funds

  • A bond fund provides instant diversification
  • Benefit of professional fund manager
  • Dividends can be paid more frequently than bonds (bonds usually pay twice a year)

The drawbacks of investing in bond funds

  • Bond funds typically have a higher expense ratio
  • Risk decreases as you hold a bond as it nears maturity. It is not true of a bond fund as it constantly turns over the portfolio
  • Dividend from bond funds fluctuate based on portfolio holdings at that time