Bonds Vs. Bond Funds

Editor’s note: This article is part of our “How and Why to Invest in Bonds” series. Click here to read other articles.

Some brokerage firms like to tell clients they should buy bonds instead of bond funds, but for many investors, that is rarely a good idea. There are several possible advantages to investing in a mutual fund's portfolio of bonds rather than buying bonds directly.

The primary reason is the ease of diversification.

Bonds are typically issued with face values of $1,000, but you may need to buy a block of several bonds to obtain decent pricing. To assemble an individual-bond portfolio that's reasonably diversified across market sectors, $100,000 is often cited as the minimum threshold at which a portfolio of individual bonds could make sense over a bond fund. By contrast, bond-fund investors assemble a very broadly diversified portfolio of bonds for a low cost--corporate bonds, government bonds, and bonds backed by assets like mortgages--thereby aiming to reduce the damage that any one holding can inflict on their overall portfolios.

In a related vein, individual-bond buyers, particularly those without a lot of money to invest, can face high trading costs when transacting in individual bonds, which can make a real dent in returns.

Morningstar Research Services' senior analyst Eric Jacobson says that U.S. Treasury bonds are an important exception. The U.S. Treasury market is extremely large and liquid, its structures are as simple as they come, and most brokerages charge modest fees to buy and sell them at very fair prices. For pretty much everything else, the cards are stacked against you.

Professional management is also a key virtue of mutual funds, and this is arguably even more important in the realm of bonds than in stocks. That is because, in addition to evaluating bonds' interest-rate sensitivities, bond-fund managers also spend time evaluating bond issuers' creditworthiness as well as other features of the issuers and their bonds.

Part 4: To Index Bonds or Not?

The following authors contributed to this series:

Tom Lauricella, Editorial Director, Professional Audiences Christine Benz, Director of Personal Finance Sarah Bush, Director, Fixed-Income Strategies Jeff Westergaard, Director, Fixed-Income Data

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