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Bonds vs Mutual Funds, which is better for your portfolio?
It doesn’t matter if you are looking at bonds to help offset some of your investment portfolio risks or you’re just learning about the bond market. We will teach you everything you need to know to understand how bonds work. You can use this to help ensure that they align with your financial strategy and your financial goals.
What are Bonds?
Investopedia explains a bond as a fixed income instrument representing a loan made by an investor to a borrower (typically corporate or governmental).
I have always explained it in this way. When you own individual stock, you become a part-owner in that company. That means if the company does well, you get to capture the upside through rising stock prices and potentially higher dividend payouts. If the corporation does poorly or fails to perform as it should, the stock price could fall, or the company could shut down.
With a bond, you act as the bank. You are basically loaning out assets to a company with the expectation that they will pay you back in a specified amount of time. These debt instruments pay you back in an interest-only fashion until they come due. The final payment consists of a balloon payment of your last interest payment as well as your full principal payment.
You are issued a coupon rate when the bond is issued. Since these are debt instruments, their returns will be based on the bond issuer’s credit risk. In simple terms, companies have a credit rating just like we do. If they have a high “credit score,” or, in bond speak, a high bond rating, they will offer lower rates to the bond owner.
If the credit quality of the bond issuer is lacking, the rates are higher. These are often referred to as “high yield” bonds or junk bonds. The reason for this is because there is a higher risk of default. A bond is also just one asset class you can invest in. Just like with all investments, do your research.
What to Know – Bonds
As a bond investor, these are vital pieces of information to know:
- Interest Rate
- Interest Payments
- Interest Rate Risk
- Credit Quality of Issuer
- Total Return after Taxes
Let’s quickly break down what each of these means. That way, when you are looking at various bonds, you know what you’re actually looking at and can make a solid decision on what is the best move for your financial situation.
Interest Rate
The interest is the amount you receive for loaning your assets to the bond issuer. On $1,000, a 1% interest rate represents a return of $10. A 5% return would be a return of $50.
Interest Payments
This is the frequency of the interest payment that you receive. Typically a bond will pay out interest semi-annually. A $1,000 bond returning 5% a year would pay $25, twice a year.
Interest Rate Risk
Interest rate risk is the potential of losses if there is a change in interest rates. If you see a rise in interest rates, then the bond’s value will decrease, and if interest rates fall, the value of the bond increases. This only really comes into play if you plan to sell the bond before maturity.
Credit Quality of Issuer
This is the credit quality assigned to the bond issuer by a credit rating agency such as Standard and Poors. AAA for S&P is considered the best rating, and CCC would be the worst. Typically, a rating of BBB or better would be regarded as an investment grade. Lower than that, and you’re hitting the speculative realm of bond investing.
Total Return after Taxes
When you look at the return on a bond, you want to find one that offers you the best return. If you are in a high tax bracket, you may be able to invest in a municipal bond tax-free versus a corporate bond and pay capital gains taxes on them. Feel free to look at the Tax Equivalent Yield Calculator by IQCalculators.com.
Calculator for Tax Equivalent Yield
What are Bond Funds?
Bond funds are similar in scope to mutual funds. If you’re familiar with how a mutual fund works, which consists of hundreds, if not thousands of companies and their individual stock, a bond fund is similar. With a bond fund, you are putting your money into a pool with other investors so that you can buy many bonds at once.
A fund manager goes out into the open market and buys up bonds with different interest rates, maturity dates, and credit risks.
This gives you instant diversification when compared to a traditional bond. When you buy a single bond, your investment is in that one company. If it fails and can’t afford to pay off its debtors (which includes you), you’re out of your investment. With a bond fund, you’re diversifying your risk over hundreds, if not thousands of bonds.
Besides just bond mutual funds, you have bond ETFs and bond index funds. The difference between bond mutual funds and bond ETFs is that a bond mutual fund typically holds bonds as they mature. The ETF typically tracks an underlying index and tries to match the return. With mutual funds, you buy at NAV at the close of business, and with an ETF, you can purchase intraday.
With bond funds, there are a few things that you want to keep an eye on before you invest.
- Net Asset Value (NAV)
- Management Fees
- Total Return
- Types of Bonds Held
Net Asset Value
The Net Asset Value is similar to stock investment. It represents the share price for the bond fund. If you invest $1,000 and the NAV is $50, you would hold 20 shares of the underlying bond fund.
Management Fees
Management fees are typically a hidden piece that many fail to realize actually exists. When you are reviewing various bond funds, you want to look at the net expense ratio. This is the amount you pay each year in fees. Part of this goes to the fund manager. Some go for portfolio management fees, some of it for marketing.
The fact is, you’re paying those fees. If you’re getting a return of 2% and your net asset fee is .50% – you’re getting an actual yield of 1.5%. Be careful with how much you’re spending on management fees because they can destroy your returns.
If you work with a financial advisor, there could also be a professional management fee that they charge you. The fee typically ranges from 0.5% up to 2.5% and is based on your initial investment or your assets under management (AUM). The cost varies based on if you’re invested in the stock market or managing your assets through a brokerage account on your own. Typically you would talk to your financial advisor and see if you’re in a managed account.
Total Return
Remember, past performance is no guarantee for future results. One of the benefits of a bond fund is that it is invested in thousands of bonds. This gives you instant diversification and allows them to diversify with some high-yield bonds to raise their yields. Be mindful of how any mutual fund invests and make sure that it meets your investor risk tolerance.
Types of Bonds Held
Make sure to review any bond fund presented to you. Each fund will have its own expertise and portfolio mix. Some will take more risk and invest in high-yield bonds, also known as junk bonds. Some will only be focused on short-term government notes. Make sure you understand the goal of the fund you’re buying.
Types of Bonds
- Corporate Bonds
- Municipal Bonds
- Government Bonds
- Real Estate Investment Trusts
Corporate Bonds
When a company needs to raise capital, it goes about this by issuing debt instruments like bonds. When the bonds are sold to a bond investor, they are given maturity date, coupon rate, and any terms around the bond, whether it is callable or not. There are two main types to talk about.
Investment Grade – These bonds typically have a higher credit quality overall. These bonds are rated as BBB- or better for Standard and Poors, or Baa3 with Moody’s.
High Yield – These bonds tend to be junk bonds or speculative in nature. The credit quality for these bonds is lower and involves far more risk. Due to the bonds’ quality, you’re usually able to get a higher interest rate for the added risk you’re taking.
Municipal Bonds
Also referred to as muni-bonds. Munis are issued by the state, city, county, and other government entities. You receive certain tax advantages with muni-bonds. There do not have to pay federal income tax on your earnings. You may also avoid state taxes if you purchase it in the same state that you live in. To learn more about your specific scenario, talk to your tax advisor or your financial advisor.
General Obligation Bonds – Unlike corporate bonds, General Obligation Bonds rely solely on the issuer’s full faith and credit. Taxes back these bonds, and the income earned pays the interest on the outstanding bond.
Revenue Bonds – Rather than using taxes like G.O. Bonds, revenue bonds use income streams to pay back bondholders. You will usually see revenue bonds for highway tolls, airports, or public transport. Pay attention to whether or not the Revenue Bond is “non-recourse” or not. A non-recourse bond means that they do not have to pay back the outstanding debt if it fails.
Conduit Bonds – A Conduit Bond is one which the government offers to issue a muni-bond for some non-profit, like a college or hospital. These individuals use the funds to build new additions and pay the issuer. The issuer pays back the bond holder when they are paid. Suppose the non-profit fails to pay them their principal and interest. In that case, they are usually not liable to pay back the interest payment to the bond owner.
Government Bonds
Government bonds, notes, bills, and TIPS are issued by the full faith and credit of the United States government. These are as safe as a bond can get. I mean, we trust our government to pay us, don’t we? Due to the secure nature of these loans, they also typically pay the lowest rate of interest.
Treasury Bills – Treasury bills are as short-term as you can get. Typically their maturity can range from a few days to 52 weeks. This also offers the lowest interest rate.
Treasury Notes – The main difference between Treasury Bills and Notes are their length. They tend to range from 1 to 10 years for their maturity.
Treasury Bonds – Treasury bonds are the longest of all. They typically range from 10 – 30 year maturity time frames. This tends to carry the most significant interest rate risk. The bondholder receives interest on a semi-annual basis.
Treasury Inflation-Protected Securities – TIPS are a special kind of bond that ranges from 5, 10, or 30-year notes. These bonds adjust with inflation, which can actually increase your returns in a higher inflationary period. The principal is adjusted based on the Consumer Price Index and allows it to be calculated regularly. Just like with treasury bonds, interest is paid out on a semi-annual basis.
There is one thing I want to explain quickly. Real Estate Investment Trusts (REITs) can issue bonds, but a REIT itself is not a bond.
Differences Between Bonds and Bond Funds
| Description | Individual Bonds | Bond Funds |
|---|---|---|
| Management Style | Managed by the investor | Professional management that can be active or passive |
| Minimum Investment Amount | Preferably large | Small |
| Fees | The commission charged per bond may be higher for small purchases than for large purchases. | Management fees and sales fees depending on the share class |
| Income Frequency | Typically semiannually | Typically monthly |
| Predictable Market Value at Maturity | Yes, barring default | No |
| Option for Automatic Coupon Reinvestment | No | Yes |
| Cost Basis | Individual cost basis for each bond | Cost basis is based on the price paid for the share of the fund |
| Customization | Yes | No |
| Diversification | Harder to achieve | Easier to achieve |
See Charles Schwab’s own website at this link here for more information.
Bonds in Individual Investors Portfolio
When we look at Bonds or Bond funds we want to add to a portfolio, we add bonds to individual securities and mutual funds to diversify our portfolios. If you own bonds, you want to mix them in with other asset classes as well. Learn what your risk tolerance is and make sure you have an appropriate portfolio mix.
One thing to keep in mind is current market conditions. In 2021, we are still at an all-time low-interest-rate environment with talks of potential increased inflation. If you’re buying a bond fund, make sure that it has low costs. If you want higher returns, you’ll need to look into high-yield bonds, which tend to come with more risk.
Remember, before you make any changes, speak with your financial advisor and build a portfolio around your risk tolerance. A good rule of thumb is that you should carry equity equal to 100 – your age. If you are 50, that means you should have investments of 50% equities and 50% in fixed income, though it should match your personal risk tolerance, and this is just a generalization.
Wrap Up
We discussed the differences between a bond and a bond fund. Depending on your goal and the number of assets you have will depend on which path you want to take for your investment. If interest rates rise, a bond fund can work as an excellent hedge. A traditional bond, you will have to take a hit on receiving less interest or on your principal by selling out to a secondary market.
Ensure that you know the different types of bond funds and bonds available when you’re ready to invest. Time horizon, investment strategy, and investment-grade are critical when you build out your own investment portfolio. To learn more about index funds, take a look at this article here, and to learn how to invest with IRAs, we’ve got you covered right here.
If you have any questions that you’d like me to address in the future, please feel free to reach out to me.
Stay Happy!
Disclaimer: Just My Little Mess does not provide tax, investment, or financial services and advice. The information is presented without considering the investment objectives, risk tolerance, or financial circumstances of any specific investor. It might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.