Bonds and Bond Funds

Purchasing individual bonds or bond-fund shares are two common ways to invest in fixed-income securities. While each product offers investors an array of options, the characteristics that distinguish a bond from a bond fund can help determine which fits best with your financial objectives.

Here are some things to consider when making an investment decision.

Bonds offer investors dependable income, relative safety and portfolio diversification. Because bonds typically have a predictable stream of payments and repayment of principal, many people invest in them to preserve and grow capital or to receive consistent interest income.

Purchasing individual bonds differs in several ways from an investment in a bond fund.

• Most notably, an individual bond has a definite maturity date.
• Unless an issuer defaults, if you hold a bond until it matures, it will be redeemed at par, regardless of prevailing interest rates.
• Generally, individual bonds are less affected by interest rate changes than bond funds. In fact, interest rate risk tends to decline as a bond nears maturity.
• The impact of a default will be greater on a bond than on a fund portfolio because the fund’s diverse holdings help to minimize the effects of problems with a single bond.
• The minimum investment required to purchase a single bond is about $1,000, though bonds are generally sold in $5,000 increments.
• Bonds can be purchased from several sources, including investment and commercial banks, brokers and firms that specialize in selling debt securities. In addition, Treasury bonds can be purchased directly from the Federal Reserve.
• Popular, actively-traded bonds and high-credit-quality bonds, as well as those from well-known issuers are usually the most liquid, and thus easier to sell.
• The cost for purchasing a bond, usually a broker’s commission, is added to the price of the bond. This can range from about one percent to five percent of a bond’s original value.

A bond fund is a portfolio of fixed-income securities that offers the convenience of professional selection and portfolio management by an individual manager or an investment team. Its structure also allows investors to easily and inexpensively diversify risks across a broad range of bonds. Bond funds can also stabilize the volatility of owning stock funds.

Rather than purchasing individual bonds, investors purchase shares in the bond fund. The price of a share (the “net asset value” or “NAV”) is calculated by dividing the fund’s total assets by the number of shares outstanding. Bond funds make money from the interest earned on the securities they own or by selling those bonds at a profit. Similar to individual bonds, bond funds provide investors with the opportunity to collect these interest dividends and capital gains or to reinvest them back into the fund.

Many types of bond funds are available. While the two main categories of funds are those that provide taxable or tax-exempt income to investors, bond funds also vary based on maturity (short-term, long-term), type of issuer (municipal, corporate, etc.), strategy, investment objective and credit quality. There are several ways in which bond funds differ from owning individual bonds.

• Bond funds have no single maturity date.
• Investors can sell their shares back to the mutual fund company at any time, at a price equal to the fund’s current net asset value.
• A fund’s net asset value will move in response to factors such as interest rates, credit quality and currency values. It may also be affected by overall flows of cash in and out of bond funds. Because it tracks interest rate fluctuations, the future value of the fund cannot be known with certainty at any point in time.
• Due to the funds’ constant maturity, interest rate risk is likely to remain constant throughout the life of your investment.
• The minimum investment in an open-end fund ranges from about $1,000 to $5,000.
• Bond funds can be purchased directly from the fund management company or through brokers and banks, as well as through retirement plans such as 401Ks and pension plans. In addition to open-end mutual funds, bond portfolios can also be purchased via unit investment trusts, closed-end funds, exchange-traded funds and money market funds. (see sidebar)
• Bond funds tend to be highly liquid. However, a fund’s liquidity can be affected by factors such as supply and demand, the attractiveness relative to other investment sectors and the reputation of the fund management company.
• In addition to a sales commission, investors may be required to pay annual management fees, generally based on a small percentage of the net asset value of the fund, to cover the costs of active portfolio management. Interest earned is passed on to investors once management fees have been deducted.

Other tax or financial issues may affect your investment decision. Consult your tax or investment advisor for advice for your situation.

Open end mutual fund:

Also known as an open-end investment company, open-end mutual funds invest the pooled cash of many investors in order to meet the fund’s stated investment objective. Mutual funds stand ready to sell and redeem their shares at any time at the fund’s current net asset value: total fund assets divided by shares outstanding.

Closed-end fund:

Bond portfolios created with a fixed number of shares, which trade as listed securities on a stock exchange. After the initial offering, existing shares can only be bought from existing shareholders. Closed-end funds pass interest earned on the underlying bonds through to investors.

The funds can use borrowed money, or leverage, to increase potential returns or yield. Closed-end funds can also issue preferred shares, employ bank loans or lines of credit, issue short-term notes or engage in reverse repurchase agreements (repos) in order to increase potential returns.

Unit investment trust:

A portfolio set up at the fund’s launch which remains unchanged. As each bond reaches maturity, the trust holder receives payments until the fund dissolves. They provide a steady, periodic flow of income to investors.

Exchange traded fund:

An investment company, similar to an index mutual fund, which trades on an exchange like stocks. Shares, created by institutional investors, can be bought and sold through a broker or a brokerage account, but not directly from the fund.

Money Market fund:

A highly liquid, open-end mutual fund which invests only in short-term debt obligations with maturities ranging from one day to one year. The fund’s net asset value remains constant at $1 per share, and interest is paid monthly.