This article is adapted from a 2000 edition of the retired Retiree Portfolio report .

You want to add bonds to your portfolio, but you're not sure if you want to buy individual bonds or a bond mutual fund. Perhaps Betty and Fred can help you out.

Betty is a retiree who prefers individual bonds. On Saturday mornings, after fiddling with the engine of her convertible Mustang, 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 five categories.

1) The "fixed income"
Betty recently invested $10,000 in corporate bonds that will pay 7% a year for the next five years. Like most bonds, the interest is paid semiannually. Thus, she'll receive two payments a year of $350 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 7%.

However, the "fixed income" of a bond fund is not fixed. The dividend 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) Principal
On the day that Betty's bond matures, she will receive $10,350: 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.

This has worked to the benefit of bond mutual fund investors over the past couple of decades, due to the inverse relationship between interest rates and bond prices. Since interest rates have been on a two-decade decline, bond prices have been likewise climbing. The NAVs of such bond funds as Pimco Total Return and Vanguard Total Bond Market Index have doubled over the past decade.

However, as Fool Mathew Emmert explained in Broken Bonds, this can't go on forever. With interest rates at 40-year lows, how much lower can they go? As we say here in the South, "The rates shall rise again," which will cause the value of bonds to fall.

If you own individual bonds, the issuer doesn't default, and you hold the bond until maturity, this is a non-event. You'll get back exactly how much you invested.

However, this is not the case with bond funds. They do not "mature" and do not have a contractual obligation to return an investor's principal. So, when interest rates climb, the value of bond funds will fall. This drop will be more dramatic for funds that invest in long-term bonds.

3) Costs
Betty (who Fred affectionately refers to as "The Bond Bombshell") bought her bonds through a discount broker. She paid $50 in commissions.

Fred (who 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. That means his share of the expenses to run the fund is $77 a year. In seven years, when Betty's bonds matures, her costs still will have been $50. Over those seven years, Fred will pay $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., a 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.

4) Capital gains taxes
The only way Betty would pay capital gains taxes is if she sold her bonds before they mature and she received more than $10,000 for the sale.

There are two ways Fred would have to pay capital gains taxes. First, like Betty, Fred will have a gain if he sells his investment for more than he paid. Since the value of his investment when he sells will most likely not be $10,000 (his initial investment), he will have a capital gain or a capital loss.

Secondly, if the fund manager sells a bond for more than it's worth, that capital gain will get passed on to Fred and his fellow shareholders. This happens every year to mutual fund investors. Managers buy and sell securities all year long, incurring capital gains and losses along the way. Even if the fund distributes tax-advantaged income -- from investments in Treasuries or municipal bonds -- the capital gains are still taxable. Furthermore, this may happen even if the NAV of the fund didn't actually increase.

5) Knowing the investment
Betty knows what she bought. She knows which company issued the bonds, and its credit rating. Her $10,000 is fully invested in those bonds.

As for Fred, he knows that he invested in an intermediate-term corporate bond fund, but he doesn't know which companies issued those bonds, or their credit ratings. The fund does publish a semi-annual report, but that's just a one-day snapshot of the fund. His fund has a turnover rate of 150%, which is about average for bond funds. That means that, in the course of a year, the fund manager has sold all the bonds that were in the fund at the start of the year, and has disposed of half of the second batch of bonds, too. Plus, the fund is never fully invested, because a portion of the fund must be kept in cash to meet administrative needs and redemptions.

Both sides of the fence, and common ground
When Betty and Fred get in 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 and maybe capital gains to boot."

Fred: "Well, you put all your faith in a handful of companies. What if one of those companies defaults or goes bankrupt? 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. As for costs, I read an article on arguing that low-cost funds are more cost-efficient for fixed-income portfolios of $50,000 or less."

Betty and Fred agree on two things. First, there aren't many good reasons to buy Treasury bond funds. U.S. government securities can be bought from Treasury Direct, commission-free. Because Treasuries are so safe, there's no need to pay an expense ratio (or worse, a load) for the diversification.

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.

Robert Brokamp is the co-author of The Motley Fool Personal Finance Workbook and author of The Motley Fool's Guide to Paying for School . The Motley Fool is investors writing for investors .