Bonds and bond mutual funds can add diversification and balance to your portfolio as well as provide income. But although they are the same type of investment – basically loans to corporations and municipalities in exchange for interest payments and repayment of principal – they act very differently within your portfolio.
The Buzz on Bonds
When you buy an individual bond, you are getting a certain amount of predictability. The issuer promises to repay the principal within a given time frame (maturity) and pay you a stated rate of interest in the meantime. As with many other investments, the rate of return is generally linked to the risk level – the higher the risk of default, the higher the interest rate paid. Treasury bonds, backed by the full faith and credit of the U.S. government, are considered least risky. Corporate and municipal bonds rated AAA by Standard & Poor’s or Aaa by Moody’s Investors Service are also considered low risk. Those rated below BB, often called high yield, or "junk bonds," are the riskiest investments.
The value of an individual bond varies with the market. For example, if interest rates go down, the price of bonds go up and vice versa. But these price fluctuations will not affect you unless you decide to sell your bond before maturity. Provided the issuer does not default, the face amount of the bond is the amount you will be paid at maturity regardless of what the bond market is doing.
For example, if you buy a 10-year, $10,000 bond with a 3% coupon (interest) rate, you will be paid 3% a year and, at the end of 10 years, you will be paid $10,000. That is called selling at par. However, if you decide you want to sell that bond before the 10-year term is up, you may or may not be able to sell it for $10,000. If new bonds are paying 4% interest, then no savvy investor will want to pay you $10,000 and earn only 3% interest. You may have to sell it at a discount to make up for the fact that the buyer could make more on interest elsewhere. On the other hand, if new bonds are paying only 2%, you may be able to sell your bond for more than $10,000 (a premium).
Consider individual bonds if you:
- Have enough money to invest to diversify your bond purchase;
- Don't expect to sell before maturity;
- Want to control when you pay taxes; and
- Want more predictability than a bond mutual fund may offer.
The Facts about Funds
The biggest difference between an individual bond and a bond mutual fund is that a fund has neither a fixed yield nor a contractual obligation to repay the principal amount at maturity. Because bond fund managers buy and sell bonds, the net asset value (NAV) of the fund goes up and down based on the market and you may receive capital gains or incur losses. With an individual bond, you would not realize a capital gain or loss unless you sold the bond before its maturity date at a higher or lower price than you paid for it.
Consider a bond fund if you:
- Want more diversification than you may be able to achieve with individual bonds;
- Need an affordable initial investment and
- Value professional management. Other advantages of a bond fund include the ability to reinvest dividends and redeem your shares at any time at the NAV.
Bond Mutual Funds in Your Plan
Your 403(b) may offer a variety of bond funds or a balanced fund that includes a mix of stocks and bonds. You may want to ask your financial advisor for more information. Learn more about the investments within a particular fund available in your plan by visiting www.403bcompare.com.