If you’re looking to invest in the bond market, there are two primary options available to you: individual bonds and bond mutual funds. While both offer the potential for steady income, portfolio diversification, and relatively low risk, there are some key differences between the two. In this article, we will explore why owning individual bonds can be a better choice than owning bond mutual funds.
First and foremost, owning individual bonds gives you more control over your investments. When you purchase an individual bond, you know exactly what you’re getting – a fixed income security with a specific maturity date and interest rate. You can choose bonds with maturities that match your investment horizon, and you can select individual bonds with credit profiles that meet your risk tolerance.
On the other hand, when you invest in a bond mutual fund, you’re essentially pooling your money with other investors to buy a portfolio of bonds. While this can provide diversification benefits, it also means you have less control over the specific bonds in your portfolio. You may not know exactly what bonds you own, and you may not be able to customize your portfolio to match your specific needs.
Another advantage of owning individual bonds is they offer more predictable returns than bond mutual funds. When you own an individual bond, you know exactly how much income you’ll receive and when you’ll receive it. As long as the issuer doesn’t default on the bond, you can expect to receive the par value of the bond when it matures.
In contrast, bond mutual funds can have fluctuating returns, and the income payments can vary depending on the bonds held in the portfolio. In addition, if interest rates rise, the value of the bonds held in the mutual fund may decrease, resulting in a decline in the value of your investment.
Furthermore, owning individual bonds can be more tax-efficient than owning bond mutual funds. When you own an individual bond, you receive regular interest payments, which are subject to federal and state income tax. However, if you hold the bond until maturity, you won’t owe any capital gains taxes. This can be especially beneficial if you’re in a high tax bracket.
In contrast, bond mutual funds can generate capital gains taxes if the fund manager sells bonds in the portfolio for a profit. These capital gains are distributed to shareholders, who are then responsible for paying taxes on them. This can result in a higher tax bill, even if you haven’t sold any shares of the fund.
Another advantage of owning individual bonds is that they provide more certainty in terms of cash flow. When you own an individual bond, you know exactly when you’ll receive your interest payments and when your principal will be returned. This can be helpful if you’re relying on your bond investments to provide income to cover expenses.
Bond mutual funds, on the other hand, can have fluctuating income payments and principal values, which can make it more difficult to plan your cash flow needs. In addition, if you need to sell shares of the fund to generate cash, you may be forced to sell at a loss if the value of the fund has declined.
One potential downside of owning individual bonds is that they can be more expensive to purchase than bond mutual funds. This is because you’ll need to buy multiple bonds to achieve the same level of diversification as a bond mutual fund. In addition, you may need to pay a commission to purchase individual bonds from a broker.
However, the costs of owning individual bonds can be offset by the benefits they provide. For example, if you have a large amount of money to invest, owning individual bonds can provide greater flexibility in terms of selecting bonds that meet your specific needs. In addition, if you hold the bonds until maturity, you won’t need to pay any ongoing management fees, which can be a significant cost savings over time.
As fiduciary money managers who work primarily with clients on comprehensive retirement plans, B&C Financial Advisors utilizes individual bonds to plan more accurately for cash flow and realize more predictable returns. If you are interested in learning more about adding individual bonds to your overall financial plan, do not hesitate to contact us.