Bond funds vs individual bonds: which way of owning bonds fits you?

What is the difference between a bond fund and an individual bond?#

An individual bond is one loan to one issuer, with a set coupon and a set maturity date — see what a bond is. A bond fund is, in FINRA's words, a mutual fund or exchange-traded fund that invests in bonds^[1]. Investor.gov adds closed-end funds and unit investment trusts to the list of fund types that invest mainly in bonds or other debt^[2].

The SEC's guide to funds notes that because there are many different types of bonds, bond funds can vary dramatically in their risks and rewards^[3]. A fund may hold one type of bond, such as municipal bonds, or a mix^[1]. So "bond fund versus bond" is really a comparison of two ways of holding the same kind of asset.

Do you get your money back at maturity with a bond fund?#

This is the biggest practical difference. With an individual bond, the SEC notes that if you hold it to maturity you are paid the stated interest and the bond's face value, whatever its price did along the way^[6] — assuming the issuer pays.

A bond fund makes no such promise for the fund as a whole. FINRA's guidance to brokers says bond fund customers should be aware that return of principal is not guaranteed, because the fund's net asset value fluctuates with the prices of the bonds it holds and with the adviser's buying and selling^[4]. The SEC's fund guide adds that the price at which you buy or redeem mutual fund shares depends on the fund's net asset value, or NAV^[3].

How do the risks compare?#

Owning a fund does not remove bond risks; it reshapes them. FINRA's guidance to brokers notes that, as with direct bond ownership, bond funds have the same interest rate, inflation and credit risks as the bonds they own^[4]. The SEC's guide lists credit risk, interest rate risk and prepayment risk for bond funds, and notes that funds holding longer-term bonds tend to have higher interest rate risk^[3].

Interest rate risk. FINRA suggests checking a bond fund's duration on its fact sheet^[7]; duration estimates how much the fund's value may move for a one-point change in rates. Our note on why bond prices fall when rates rise explains the mechanism. Investor.gov puts it bluntly: when interest rates go up, the value of debt securities goes down, so you can lose money in any bond fund^[8].

Credit risk. Here funds have an edge. The SEC notes that spreading investments across a wide range of companies can help lower risk^[3]. With $10,000 split across ten individual bonds, a single issuer that paid nothing back would cost $1,000 — 10% of the principal. A fund holding many more bonds dilutes any one default further, though it cannot remove credit risk. See bond credit ratings explained and diversification explained.

What do bond funds and individual bonds cost?#

Funds charge ongoing fees. FINRA notes that bond funds charge fees and expenses paid by investors, which can vary widely from fund to fund and across share classes^[1], and its guidance to brokers stresses that, unlike individual bonds, fund shares carry ongoing fees^[4]. The SEC lists "costs despite negative returns" among the disadvantages of funds^[3]. See expense ratios explained.

Individual bonds have their cost up front, often hidden in the price. When a broker-dealer sells you a bond from its own inventory, it is generally paid by charging a price above the market price, called a markup; when it buys from you, the gap below market is a markdown^[5]. Investor.gov notes brokers typically do not list markdowns separately on confirmations, and that actively traded bonds may have lower markdowns^[9].

Some simple arithmetic, done in code: a 0.50% yearly expense ratio on $10,000 costs about $50 a year, or $250 over five years before growth; a 0.05% ratio costs $5 a year. A one-time 1% markup on a $10,000 bond purchase costs $100. Which is cheaper depends on the fund's fees, the bond's markup and how long you hold.

Which is easier to buy, sell and manage?#

Bond funds can be bought and sold through an investment professional, a brokerage website or app, or the fund directly^[1]. The SEC lists professional management, diversification, low minimum investments and the ability to redeem shares readily as advantages of funds^[3]. The trade-off is control: fund investors cannot directly influence which securities the fund holds^[3].

Individual bonds trade differently. FINRA explains that most bonds trade through dealers who buy and sell for their own account, and that bonds which trade often tend to have more buyers and greater liquidity than bonds that trade sporadically^[10]. Investor.gov adds that actively traded bonds may have lower markdowns^[9], so selling a rarely traded bond early can cost more. If you plan to hold to maturity, that matters less.

1. 1

   Decide when you need the money

   If you need a known amount on a known date, an individual bond that matures then lines up with that need. If you have no fixed date, a fund's lack of maturity matters less.

2. 2

   Check how much you are investing

   Spreading credit risk across many issuers is easier through a fund, especially with smaller sums.

3. 3

   Compare costs on both sides

   Look up the fund's expense ratio and ask the broker for the markup on any individual bond.

4. 4

   Look at the risk numbers

   For a fund, read its duration and credit quality on the fact sheet. For a bond, read its maturity, coupon, rating and call terms.

What mistakes do beginners make?#

1. Assuming a bond fund behaves like a bond at maturity

   A fund's adviser keeps buying and selling bonds, so the fund does not promise a date when it pays back what you put in. FINRA stresses that return of principal is not guaranteed^[4].

2. Ignoring the fund's ongoing fees

   Fees come out every year, whether returns are positive or negative. Check the expense ratio before comparing yields.

3. Buying a few bonds and calling it diversified

   Three or four bonds from similar issuers leave you exposed to one default. Either spread across many issuers or accept the concentration knowingly.

4. Overlooking the markup on individual bonds

   The cost of buying a bond is often inside the price. Ask how much it is, and compare more than one firm.