Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

A: The short answer is yes, you can. But there could be drawbacks.

Buying an individual bond gives you a fixed rate of return, or yield, and if you hold the bond until maturity (provided you buy a bond that does not default), you will receive your interest and principal regardless of interest-rate fluctuations.

Bond fundholders, by contrast, will not necessarily be assured that their principal value will not decline, and the interest they receive from their bond fund (a basket of securities that can fluctuate in value from day to day) could also fluctuate.

In a period of rising interest rates, which tends to make already-existing bonds with lower coupons less valuable than the new bonds with higher rates, bond-fund shareholders can see a reduction in their principal values. The upside, however, is that sometimes the manager is able to partially offset some of those price declines by swapping into higher-yielding bonds.

Thus, a crucial difference between a bond fund versus an individual bond held until maturity is that, with bond funds, there is a greater chance that your principal value when you sell will be different—for better or for worse—from the amount you put into the bond fund in the first place.

In an effort to "normalize" the interest-rate environment following its $4 trillion economic stimulus plan, the Fed has raised its benchmark interest rate six times since December 2015. This means it is possible that the bonds in a bond portfolio will decline in value over the time that you own a fund. Individual bondholders will not have to contend with that same issue and if their bond issuer makes good on its debt, the amount they put in is the amount they get back.

At the same time, it is unwise to derive a false sense of security from investing in individual bonds. Even if individual-bond buyers are able to circumvent interest-rate risk by holding individual bonds until maturity, they may court risk on other fronts, including: a lack of knowledge in the absence of professional management, the inability to diversify without a significant amount of assets, and the impact of trading costs on take-home yield and total return.

Smaller investors can safely buy individual Treasury bonds and high-quality corporates but might want to consider a fund if they are delving into municipal bonds and lower-quality corporate bonds. And even TIPS, which are high quality but have trading peculiarities, may be better held in a fund than individually.

 

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