Bond Funds vs. Bond ETFs: What are the Differences?

Both bond mutual funds (or simply, bond funds) and bond ETFs have bonds or another type of debt securities in their investment portfolio but there are distinctions that active investors should be aware of. Bond funds are mutual funds where a manager combines multiple investor’s money and invest the pooled money in fixed income instruments. On the other hand, a bond ETF is a fund that tries to mimic an index of bonds in order to mirror the performance of that index.

Learning About Bonds

It’s worthwhile to take a short break and make sure we understand what a bond is before moving further to bond funds and bond ETFs. A bond is an effective financial obligation closely associated with an IOU through which governments or companies can borrow money. When you purchase a bond, you are supplying the issuer money for the rights to receive interest payments and the bond’s face value at its due date. Bonds are generally considered to have a lower level of volatility compared to individual equities, and their own returns are predictable interest payments.

Defining Individual Bonds

Bonds usually pay interest twice a year and have fixed principal values (also called face or par values) that are repaid at maturity. Even though par values are fixed, the price of a bond can change in the secondary market based on interest rates. If rates go up, bond prices usually go down, and vice versa. As a bond gets closer to its maturity date, its price generally moves closer to its par value. Holding a bond to maturity can have an opportunity cost: If rates rise, you might miss out on higher interest payments from newer bonds.

The main benefits of owning individual bonds, assuming no default, are:

• Reliable income: If you have regular expenses, like college tuition, a steady income stream can be really helpful.
• Predictable value at maturity: If the bond isn't callable, you'll get the par value at maturity, which can help you ignore price fluctuations if you plan to hold it to maturity.
• Your own cost basis: The bond cost factor includes the original price you paid for the bond, and any variation in price between premium and discount qualifies as the cost basis when it comes to taxes.

The downsides to owning individual bonds are:

• Need for diversification: To go across asset classes and issuers, you obviously require many bonds, which is costly and difficult in most instances.
• Less attractive pricing: Institutional investors usually get better prices because they buy in large quantities. It's important to check the price you're paying for individual bonds.
• Time-consuming research: There are thousands of bonds from many issuers, each with its own characteristics. Researching and managing a bond portfolio can take a lot of time.

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Looking at Bond ETFs

Bond ETFs are basically bundles of bonds that you can trade on an exchange, just like stocks. It provides you with a range of distinct bonds or allows you to trade the existing bonds during the day. Neither are bond funds like mutual bond funds whose prices are frequently changing constantly during the trading day.

Pros of Bond ETFs:

• Trading Flexibility: You can purchase and liquidate them at any time of the trading period.
• Lower Fees: Often, their operating expense is lower than that of bond funds.
• Price Transparency: It’s possible to view prices and how they progress during trading sessions.

Cons of Bond ETFs:

• No Active Management: They may lack flexibility when it comes to responding to the changes within the market.
• Trading Costs: Every trade that one took might have a commission.
• Price Discrepancy: The market price can be different from the actual value of the bonds.

Bond Mutual Funds

Bond mutual funds hold a bunch of different bonds from various issuers, with different maturity dates, interest rates, and credit ratings. Unlike individual bonds that pay interest twice a year, bond funds usually make monthly payments, which you can take as cash or reinvest.

Pros of Bond Funds:

Diversification: You get a wider mix of bonds for your money.
Better Pricing: Funds generally get better deals on bonds compared to individual investors.
Professional Management: Experts manage the fund, which is especially useful for riskier bonds. They can buy or sell bonds based on market conditions, potentially boosting returns.

Cons of Bond Funds:

Management Fees: Actively managed funds can have higher fees, which might eat into your returns.
Fluctuating NAV: The net asset value changes with the market, so there's no guarantee on what it’ll be in the future. This makes planning harder compared to individual bonds.
Complex Taxes: Your tax basis is more complicated because the fund pools money to buy bonds. Plus, you don't control when bonds are bought or sold, which can lead to unexpected capital gains taxes.

Individual Bonds vs. Bond Mutual Funds

Management Style

Individual Bonds: Managed by the investor.
Bond Mutual Funds: Professionally managed, can be active or passive.

Minimum Investment Amount

Individual Bonds: Preferably large.
Bond Mutual Funds: Small.

Fees and Costs

Individual Bonds: Usually a commission to buy or sell, but no ongoing fees.
Bond Mutual Funds: Management fees and sales fees depending on the share class.

Income Frequency

Individual Bonds: Typically semiannually.
Bond Mutual Funds: Typically monthly.

Predictable Market Value at Maturity

Individual Bonds: Yes, unless there's a default.
Bond Mutual Funds: No.

Option for Automatic Coupon Reinvestment

Individual Bonds: No.
Bond Mutual Funds: Yes.

Cost Basis

Individual Bonds: Individual cost basis for each bond.
Bond Mutual Funds: Cost basis is based on the price paid for the share of the fund.

Customization

Individual Bonds: Yes.
Bond Mutual Funds: No.

Diversification

Individual Bonds: Harder to achieve.
Bond Mutual Funds: Easier to achieve.

Investments Should Be Based on Your Preferences

 All the pros and cons for individual bonds and bond funds need to be placed into the context of your preferences and circumstances. What works well for you might not work well for others, and vice versa. The table above is a good starting point for deciding what is better for you. There are three important considerations when determining whether an individual bond or bond fund is better for you: the amount you have to invest, your financial goals, and your behavioral preferences.

The amount of assets you have to invest in your bond portfolio is a key consideration when determining whether to invest in individual bonds or bond funds. Individual bonds have denominations that can be cost-prohibitive for some investors. Add in how many individual bonds an investor needs for sufficient diversification, and the dollar amount continues to rise. For some, it might make sense to use a more accessible bond fund or a combination of bond funds with individual bonds.

Factors to Consider

Financial goals are another important factor to consider. If you are looking for predictable value and certainty for your financial goals, then individual bonds may be a better fit. Meanwhile, if you are looking for professional management and want greater diversification for your financial goals, then bond funds may be a better fit.

Behavioral preference is another important consideration. If seeing the NAV of your fund fluctuate and having no control over certain tax consequences makes you uncomfortable, then bond funds might not be the best solution for you. It is important to realize that while you cannot eliminate the emotions involved in investing, you can recognize how a certain investment might make you feel and adapt your investment choices accordingly.

In the long run, the difference in performance between a portfolio of individual bonds and a bond mutual fund with the same duration and credit quality, held for the same amount of time, is likely to be small, because most of what an investor gets out of investing in bonds is the income generated by coupon returns, rather than the price change. The key is to make sure the investment vehicle you choose aligns with your goals and time frame.

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Conclusion

Choosing between Bond Funds and Bond ETFs really comes down to what you're looking to get out of your investments, how much risk you're okay with, and whether you prefer hands-on management or more flexibility in trading. The more you understand about each option, the better you can match them to your financial goals.