Bond investors have two specific routes. Investors can purchase single bonds by themselves or enter bond funds which purchase bonds, which consist of hundreds or thousands of bonds built into a single portfolio. Each path has its advantages and its own disadvantages.
While equity funds place the majority of their investments in shares, Bond funds place the majority of their investments in fixed income instruments. These mutual funds use shareholder money to purchase vast groups of debt securities. These securities eventually mature and the managers of the fund reinvest the earnings. They also buy bonds after issue and sell bonds before they mature, if their analysis indicates they can yield a profit from those actions.
Unlike regular bonds, bond funds do not have fixed payouts. While a bond has a fixed total return, fund returns will vary over time. These funds own hundreds of bonds, so their returns depend on the returns of the bonds within the fund. Bonds are directly tied to interest rates, and bond funds are constantly reinvesting maturities at the current rate. If interest rates change, the average return of the bond fund will change over time. Additionally, returns increase and decrease due to active bond trading after issue but before maturity.
Bonds eventually mature, but bond funds never do. They constantly produce a varying rate of return based on the yields and market prices of their bonds. Bond funds are highly susceptible to interest rate risks unless they hold every bond to maturity. Interest rate risk is the possibility that the central bank will increase interest rates, decreasing the price of bonds below the new rates of fresh issues. The price of a bond moves in opposition to the interest rate’s change. If holding a bond to maturity the interest rate change after initial acquisition does not matter, since the change affects prices and not yields. Funds that often engage in bond trading are exposed to interest rate risks and the price changes they cause.
Bond funds are categorized by the types of bonds they invest in. The main categories are taxable bonds and untaxed bonds. Untaxed bonds consist of bonds that are immune to national, provincial, or municipal level taxation in their home nations. Typically, these tax free funds refer to those which are untaxed at the national level. They are tax exempt at any single level of government, or at all levels. These benefits depend on tax regulations, and the relationship between the bond fund’s location and the source of the bonds. Taxable bonds face the full weight of taxation levied by the government. These typically, but not always, consist of bonds issued by corporations.
Bond Funds Benefit: Diversification
The first obvious benefit of a bond fund is diversification. Purchasing a bond fund instantaneously purchases a wide array of bonds. By purchasing the bond fund, if one of the bond issuers defaults, the entire investment isn’t crucially affected. If you purchase a singular bond and the bond defaults, you lose the entire portion of that investment with the exception of your recovery rate refunds. To match the diversification of bond funds while purchasing individual bonds, you will need to purchase between two hundred and five hundred thousand dollars of bonds. If you can do this, you may want to move into individual bonds. If you cannot you will go farther purchasing bond funds.
Bond Funds Drawback: Lack of Control
The downside to the instant diversification is a lack of control over specific bonds within the bond fund. When buying single bonds, you can easily ensure that they are all triple-A credit ratings. Specific issuers can be controlled by purchasing individual bonds, possibly at the expense of diversification. You can only control ratings in bond funds by purchasing portfolios limiting themselves to the rating levels you desire, such as “A and above” bond funds. Even then, you cannot control the specific bonds in the class rating chosen by the portfolio managers.
When buying single bonds, you can also choose to easily diversify the type of bonds. If you need or desire a specific amount of inflation adjusted, emerging market, corporate, or other bonds you can easily purchase desired percentages of these bonds. You cannot change bond funds’ individual holdings. You will need to divide your portfolio by specific bond funds which specialize only within each bond category desired for ownership.
Bond Funds Benefit: Diversification
Lastly, a benefit of bond funds is their Managers. They often ladder sectors of their funds out of performance and trading necessity. You must structure the ladders yourself individual purchases. This requires substantial amounts of discipline on your end. If you don’t believe you have the time or energy to structure your own bond ladders, you should lean towards purchasing bond funds.
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