Bonds vs. Bond Funds

When it comes to the fixed-income portion of their portfolios, investors have a choice: individual bonds or bond funds -- be they open-end mutual funds or exchange-traded funds (ETFs). For many investors, bond funds make sense, because of their convenience and diversification. However, there are many reasons individual bonds are preferable. To demonstrate the pros and cons of each choice, let us introduce two retirees.

Meet Betty, who prefers individual bonds. On Saturday mornings, after fiddling with the engine of her Mustang convertible, she likes to take a walk with her neighbor, Fred. He is also a retiree, but the fixed-income portion of his portfolio is in mutual funds. In fact, that's what everyone says about him. "That Fred sure is a real fund guy."

During their walks (which sometimes lead them to the beach, other times to the park, occasionally to a monster-truck rally), they often discuss money. They've found that they're both looking for stable, safe income from their fixed-income investments. However, their respective choices have led to significantly different consequences. Those differences can be broken down into three categories.

1. The "fixed income"
Betty recently invested $10,000 in corporate bonds that will pay 6% a year for the next seven years. As with most bonds, the interest is paid semiannually. Thus, she'll receive two payments a year of $300 each. She can plan on this, and budget accordingly.

On the same day, Fred put $10,000 in the Hideyhole Intermediate-Term Corporate Bond Mutual Fund, which pays a monthly dividend, as most fixed-income funds do. Its yield is currently around 6%.

However, the "fixed income" of a bond fund is not fixed. The payment changes, depending on the bonds the fund manager has bought or sold, and the prevailing interest rates. Fred doesn't know exactly how much he'll receive from month to month.

2. Safety of principal
On the day that Betty's bond matures, she will receive $10,300: the $10,000 she originally invested, and the last interest payment. She knows beforehand when this will happen and can plan accordingly.

As for Fred, he won't know how much his initial investment will be worth in seven years, or even seven weeks. That's because the net asset value (NAV) of the fund (i.e., the price of each share of the fund) changes daily, again depending on the bonds in the fund and interest-rate fluctuations.

In fact, during the worst of the financial crisis, most bond funds dropped in value. Here's approximately how much several ETFs dropped in 2008 from Sept. 9 to Oct. 10.

Source: Yahoo! Finance.

People who invested in bonds hoping they would hold up while stocks fell (the S&P 500 declined by 27% during this period) were in for a surprise. Fortunately, four of those six ETFs have recovered their losses and are actually higher today. But they turned out to be more volatile than many investors expected.

On the other hand -- and this is a really big hand -- Betty will get her $10,000 back only if the issuer is still in business. Investors in General Motors, WorldCom, and Lehman Brothers bonds can tell you that this doesn't always happen. Diversification is important with bonds, too, and you get that instantly with a bond fund, which owns hundreds of different issues.

3. Costs
Betty -- whom Fred affectionately refers to as "The Bond Bombshell" -- bought her bonds through a discount broker. She paid $50 in commissions, plus a 1% markup, the profit the bond dealer makes on the transaction.

Fred -- whom Betty calls "Elmer Fund" -- pays an annual expense ratio, as do all mutual fund investors. His fund charges 0.77% per year, which is about average for a bond fund, although bond ETFs are much cheaper. That means that his share of the expenses to run the fund is $77 a year. In seven years, when Betty's bonds mature, her costs will still have been $150. Over those seven years, Fred will have paid $539 -- assuming, for simplicity's sake, that the fund's NAV doesn't change, which is unlikely.

Fred did make sure to buy a no-load fund (i.e., an open-end mutual fund that doesn't charge a sales commission). Had he chosen a fund that charged a 3% load, for example, his costs would have risen by $300, plus there would be $300 less of his principal to earn interest.

Both sides of the fence, and common ground
When Betty and Fred get into a really heated discussion of bonds -- as we all do -- their arguments boil down to these.

Betty: "Retirees buy bonds for stable, reliable income, and they want to know that they'll get their principal back. You don't get that with bond funds, and you pay ongoing expenses."

Fred: "Well, you put all your faith in a handful of companies. What if one of those companies defaults? I've diversified by investing in a fund that owns hundreds of bonds; if one or two of the issuers go belly-up, I won't lose my shirt."

Finally, Betty and Fred agree that the "bond vs. bond fund" dilemma is an individual choice that should be made after thorough research -- and then forgotten to make more time for monster-truck rallies.