Mutual funds are extremely useful investment vehicles. With stocks, they let you buy a diversified portfolio of many different companies without a lot of money. Similarly, if you're looking for fixed-income securities, bond funds provide you with small pieces of many different bonds from different issuers, and with varying maturities. You can buy funds that focus on anything from ultra-safe bonds like Treasuries or AAA-rated corporate bonds from companies like General Electric (NYSE: GE ) to higher-yield bonds from issuers like Ford (NYSE: F ) .
However, because of how bonds are structured, there are advantages to holding individual bonds over bond funds. While the prices of bond mutual funds will rise and fall, individual bonds give you the certainty of knowing exactly how much you'll receive when they mature.
Bonds and interest rates
In general, the prices of both individual bonds and bond funds move as interest rates change. When rates fall, prices rise; when rates rise, prices fall. The longer it is until the bond matures, the greater the impact of changing interest rates on the bond's price.
Investors tend to be most concerned about potential investment losses. With both bond funds and individual bonds, you'll lose value if rates rise. The question, though, is whether or not you'll get that lost value back over time, and how long it will take for you to get back to where you started.
Buy and hold
With individual bonds, you always have the ability to hold your bonds even after interest rates rise. You'll be stuck getting a smaller interest payment than buyers of new bonds, but you'll receive the face value of the bond when it matures.
Bond funds, however, continually buy and sell their bond holdings. As a result, there's no maturity date that can provide you a deadline for getting the full amount of your investment back. In fact, you may be saddled with a capital loss on your fund shares when you sell them. The advantage, however, is that your fund will be able to buy new bonds paying higher interest, which will increase your income payments over time.
A simple example
To illustrate this, consider two investors. One buys an individual bond for $1,000 that will mature in three years. The other invests $1,000 in a bond fund that holds five individual bonds with maturities of one, two, three, four, and five years. Prevailing rates are 4% when these investors make their purchases.
If rates rise to 5% shortly after purchase, each investor will suffer a paper loss of about $30. However, over the next three years, the individual bond buyer will make back that loss and get the full $1,000 back at maturity. The bond will also pay $40 in interest each year. With the bond fund, things are a bit more complicated. On one hand, the bond fund will have individual holdings maturing each year, gaining the opportunity to reinvest the proceeds at higher rates. On the other hand, it will take longer for the four-year and five-year bonds to recover from the rate hike.
Over time, these effects tend to cancel each other out. In this example, after three years, the bond fund's value will still be down about $6 after three years, but the fund investor will get an extra $2 in interest at the end of the second year and $4 more in the third year. However, if your fund manager panics when rates rise and sells the fund's holdings at a loss, you may be stuck with that initial $30 loss forever.
In order to shelter yourself from the price fluctuations of bond funds, you may be more comfortable owning individual bonds. Realize, however, that to get the benefit of a guaranteed maturity payment, you have to be willing to hold your bonds until maturity. If you sell them early, you'll face the same losses that bond fund investors experience.
You can also learn more about the basics of fixed-income securities in our Bond Center. For more on how mutual funds and ETFs can be part of a winning portfolio, take a free look at our Champion Funds newsletter. Each issue is packed with tips from Fool fund expert Shannon Zimmerman. Make more money by signing up for Champion Funds today.