Bond funds vs individual bonds: which are better?

Bond markets endured a huge sell-off in 2022 as central banks aggressively raised interest rates to counter rising inflation. Normally prized for protecting investors when stock markets fall, bonds failed to provide this diversification as they fell in tandem with equities.

But after more than a decade of broadly unattractive, rock-bottom bond yields, many investors are now looking again at bond markets and considering the best way in: a fund or individual bonds?

With the vast array of bond funds available, selecting the right one can be a daunting task.

Instead, some people may just buy and hold an individual bond, picking a seemingly safe choice from a solid company or stable government with a good credit rating and a decent yield.

Or it could be a “ladder” of individual bonds. That is, for example, a ten-year bond ladder with a bond that matures every year. As the bonds at the lower end of the ladder mature, the proceeds can be reinvested in new long-term bonds at the top of the ladder.

There are merits to different approaches and you should consider consulting a financial adviser before making an investment decision.

However, when deciding between owning individual bonds or a bond fund, we think the main factors to consider are diversification, convenience, and costs.

1. Diversification

When investing in bonds, there is always the risk that the issuer will miss a payment of either an interest payment (coupon) or the bond’s face value (principal). In investment terms this is known as default risk.

To manage this risk and to minimise any losses when a default occurs, diversification is crucial.

While a single bond investment or a ladder consisting of 10 to 30 bonds may be vulnerable to a single default that could cover between 3% and 100% of the portfolio, bond funds usually hold hundreds of bonds at once, spread over different maturities, sectors, and geographical regions. This means that the impact of a single default on a bond fund is usually negligible.

Bond funds also offer a selection of strategies with different takes on sectors, sustainability, geographical exposure, and many can be tailored to investors’ specific needs.

2. Convenience

Investors in bond funds enjoy greater flexibility in buying or selling shares in the fund at any time and in any quantity without incurring transaction fees. In contrast, purchasing individual bonds on the primary market, where issuers sell bonds to investors to raise capital, is limited to the pre-set issuer schedule, and on the secondary market, where bonds are traded among investors, it usually incurs a commission and bid/ask spread (the difference between the purchase and sale price).

Bond funds also offer automatic dividend reinvestment, which is more convenient for investors during the period of their life when they’re saving for retirement (known as the accumulation phase) and even after beginning to spend their holdings. Rebalancing, or adjusting the allocations between a bond fund and other assets in the portfolio is also easier compared to rebalancing with individual bonds. Additionally, many bond fund managers have resources such as analysts and research teams at their disposal, which puts them in a better position to manage different technical bond characteristics such as maturity, convexity (a measure of exposure to market risk), and liquidity (the capacity of a financial market to accommodate trade volumes without significantly impacting the price, or alternatively, the effect on price due to a specific trade volume).

3. Cost

The most common costs associated with owning individual bonds are commissions and bid/ask spreads. While new bonds, or primary purchases, generally do not incur such costs, old bonds that are sold and purchased on the secondary market can have substantial commissions and bid/ask spreads. Additionally, the bid/ask spreads tend to be wider for smaller value transactions that individual investors typically make. Bond funds offer a cost advantage over regular investors purchasing individual bonds, as they pay much lower bid/ask spreads on their bond transactions. This makes bond funds a more cost-effective option for investors looking to invest in bonds.