What is a Bond Fund?

A bond fund takes investors’ money and buys bonds with it. Duh.  That’s pretty simple. But there are a host of other questions surrounding fixed income (bonds) that aren’t so obvious.

Do bonds have a place in your portfolio? If so, should you use a bond fund or buy bonds directly?

First things first. Should you own bonds? Well…… I’ll admit that I’m not a huge fan of bonds or bond funds right now for most people. Interest rates are very low right now. When rates rise (and they will) bond values will fall. That being the case, why should you own bonds at all?

Notwithstanding the caveat above, bonds make sense for some people. They provide steady income and offset the volatility inherent in equity investments. That reduces overall short-term risk and it helps many investors ride out investment storms. That’s quite a benefit if you ask me.

What are the advantages of owning bond funds vs. holding bonds out right?

When you own bond funds, you incur fund expenses. That’s a negative. But there are upsides as well. Here are 3 advantages of owning the right bond funds:

1. Genius Pool

In a galaxy far far away, bonds were safe. Companies rarely went out of business and municipalities almost never became insolvent. Sadly, we don’t live in that world anymore. Bond holders face real and dangerous risks.

If you buy an individual bond, it might be difficult for you to determine just how safe the borrower is. And the stakes are pretty high. If you lend your money to a borrower who later goes belly up, you stand a good chance of losing every penny you put into the bond. If that happens, it’s going to ruin your entire afternoon to say nothing of what it might do to your retirement income.

Of course, you could turn to the large financial rating institutions to tell you if the borrower is credit worthy or not. These are firms like S&P and Moody’s. They are supposed to put borrowers under the microscope to see how credit worthy they are. But can you rely on them?

Sadly…no. Many are now in a lot of hot water. In fact, as I write this, S&P is involved in a federal law suit. The complaints allege that this rating firm didn’t do its homework. Instead they collected their fees and gave out top marks to borrowers who didn’t deserve them. That gave investors a false sense of security and it resulted in people losing a lot of cabbage. I have no idea if the claims are true or not. But the mere fact that these companies are under Government scrutiny right now indicates that you need more than a rating agency’s opinion about a bond in order to protect your capital.

A bond fund might provide a solution to this problem. A good fund manager does their own research to gauge the risk and decides which bond securities are good bets or not. You and I don’t have that kind of firepower behind us.

2. Lots of Baskets for Your Eggs

Because the consequences can be extreme when it comes to bonds, diversification is really important. But you’d need a lot of money to have a diversified bond portfolio if you buy individual issues. Most bonds are traded in increments of $100,000 at a minimum. And most bond traders prefer to work in lots of millions. So you would need a very large portfolio (in the multi millions) if you want a diversified bond portfolio. If your last name is Gates or Trump that might not be a problem. But for the rest of us, it’s a game we just can’t play.

A bond fund solves this problem easily. Your bond fund investment is instantly spread out among hundreds of bond issues in most cases no matter how much you invest. You can read the prospectus to see how many different bonds the fund holds.

Bottom line? Bond fund investors have more diversification than most people who hold individual bonds.

3. Liquidity

When you buy individual bonds and you want to sell them before they mature, a bond trader has to locate a buyer. That takes time and it costs money. But if you own a bond fund, you can cash out any day you like. Sweet.

In the kind of bond market we have right now, this benefit can’t be undervalued. As we’ve already established, rates are very low right now. Should they rise, you might want to shift your bond holdings into other types of securities. Likewise, you might want to invest in bonds with different maturities and/or with a different kind of borrower. At some point, you might prefer to own inflation protected bonds. When you own a fund, this kind of shift is super simple to make. With individual bonds, the change is much more cumbersome.

I’ll admit that I disliked bond funds for many years. And while they still have their short-comings, bond funds are alternative risk-averse investors should consider.

Do you own bonds or bond funds? Why?