Bonds vs Bond Funds for Income and Portfolio Diversification

Below is lesson 5 in our Learn Bonds in 15 minutes video course, which coveres bonds vs bond funds for income and portfolio diversification.  You can find the transcript as well as some additional links to resources where you can learn more below this video.

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How to choose a bond fund

Buying individual bonds

Bond Duration and Interest Rate Risk

Bonds vs Bond Funds Script

Stocks and bonds normally have a negative correlation, meaning when stocks are rising in value  generally bonds are falling in value, and vice versa.  Bonds as a group are also less volatile than stocks.

These two facts combine to make bonds a really nice compliment to the stocks in a portfolio.  In times of extreme volatility like during the 2008 financial crisis, bonds can act as a nice stabilizer.  The best part about this however, is that by adding bonds to a portfolio you can generate very similar returns to an all stock portfolio, with much less volatility.  (you can learn more about this here).  So the question is not really wether or not you should have bonds in your portfolio but which is better, bonds vs bond funds.

Generally bond funds are the preferred route to achieve portfolio diversification for the following reasons:

  1. If you only have a few bonds in your portfolio and there is a problem with one of those bonds, then you are in trouble.  Unless you have a very large amount of money, it would be difficult to purchase a wide enough variety of bonds to gain the benefit of diversification.
  2. Even if you have a lot of money, buying individual bonds is less efficient from both a cost and effort standpoint than buying a bond fund.

If you are looking for portfolio diversification in the bonds vs bond funds argument, then bond funds are almost always the way to go.  You can learn more about buying bond funds here.

Where bond funds are at a disadvantage, is for generating income.  Both bonds and bond funds provide income for a portfolio.  If you buy an individual bond and hold it until maturity, then you know exactly how much money you are going to receive between the time you buy the bond and the time it matures.  A fancy way of saying this is that you can eliminate interest rate risk by buying individual bonds and holding them until maturity.

This is not true for most bond funds.  Most bond funds have a stated maturity range of bonds that they hold.  For example a long term government bond fund will always hold long term government bonds.  As the bonds in its portfolio more towards maturity the fund sells those bonds, and replaces them with bonds that are further away from maturity.

Because bond funds are constantly buying and selling the bonds in their portfolio, they do not give you the income certainty of individual bonds which are bought and held to maturity.  If interest rates go up while you are holding a bond fund, the value of the shares that you hold in the fund will decline.  If interest rates fall while you are holding a bond fund then the value of your shares will rise.

So with bond funds both the value of your shares and the income that you receive are going to fluctuate.  As its impossible to know exactly what will happen with rates going forward, its better to use individual bonds vs bond funds for income.

Thats our lesson for today, and that wraps up our learn bonds in 15 minutes course.
For more great bond information be sure to visit us at learnbonds.com follow us on twitter @learnbonds and like us on Facebook at www.facebook.com/learnbondspage

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