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One question people ask when looking to expand into the bond (“fixed income”) market is whether they should buy individual bonds or purchase a mutual fund that invests in bonds (a “bond fund”). To help you to understand bonds a little more, here is a list of points to consider. Though not a complete list, these are some of the pros and cons to review with your financial adviser:
1. Return of principal
Individual bonds are designed to repay your principal at maturity (or when the bond is called). This means that on a specific date, presuming the issuer doesn’t default, you will get back a fixed amount of money. If you know you’ll have expenses, for example, you can time your purchase of bonds to mature in time for you to pay these future bills. On the other hand, bond funds don’t have a fixed end date when an issuer promises to pay you back your principal; so, while you may get regular dividend income as long as you hold the fund, your principal is at risk.
2. Income payments
Normally, bonds pay fixed interest payments semiannually (except zero-coupon bonds, which pay back money only at maturity). With bond funds, the (normally) monthly dividends may vary in amount, so you can’t be sure of how much you’ll receive every month. One benefit of receiving the monthly payments from bond funds is that you can have them automatically reinvested, allowing for compound interest to work for you. (Interest from regular bonds cannot be automatically re-deposited in the same bond. In this case, you would need to save them up over time and then purchase another bond.)
3. Default risk
Even though bonds are generally considered as conservative investments, they sometimes default. If you own a bond that defaults, you could potentially lose your entire investment. Often, when bonds default, they do recover, but do not necessarily pay back all the money to the bond holders. Though bond funds may hold bonds that default, the risk of default is mitigated by the diversification inside the fund.
If you want to understand bonds more fully, check out the very informative bonds course at the Profile Financial Academy.
Disclaimer: This article is for educational purposes and is not a substitute for investment advice that takes into account each individual’s special position and needs. Past performance is no guarantee of future returns.