Should You Invest in Bond Funds or Individual Issues?

Bonds and bond funds generally outperformed their stock counterparts in 2011, as global growth uncertainty and Europe's debt troubles kept up demand for relatively lower risk fixed-income investments.

The sustainability of the strong bond performance is in question as prices have gotten pretty steep. Of course, as for the bullish argument, there remains a backdrop of global economic uncertainty that boosts the appeal of steady bond payments. With this bigger question looming, it's a good opportunity to review some bond basics. After all, regardless of global market conditions, bonds can be a welcome slice of a diversified portfolio.

[See top-rated funds by category ranked by U.S. News Mutual Fund Score.]

In addition to deciding how to divvy up holdings between stocks, bonds, and other securities, investors must choose what types of bond issues to invest in--government-issued paper or company debt, for instance. And for higher net-worth individuals who are looking for a little break on taxes, municipal bonds are an option.

The bigger question, however, is this: Should you go with individual bonds or give the nod to bond funds?

It depends. For example, investing in individual muni bonds requires a relatively high entry point. So if your investment is $100,000 or less, a muni fund may be the best route; it has a lower admission price. Also, in the corporate bond realm, individual issues can require a large single investment, and a roster of thinly traded issues may be nearly impossible to tap by individual investors with a relatively small account to play with. Therefore, accessing company-issued debt with the pooled resources of a fund may be the only option. The same argument can be made for tapping global bond exposure. In this case, the diversification and expertise of a seasoned fund manager may be necessary.

Funds, which charge management fees, offer simplicity and convenience, say proponents. Many tend to make monthly payouts rather than the annual or semiannual calendar that individual bonds tend to follow. For investors who seek steady income flow, that frequency may desirable.

[See Why Mutual Funds Make Sense in a Volatile Market.]

That said, bond funds can be even trickier than bonds themselves because they are not really fixed-income investments, says the Financial Industry Regulatory Authority, or FINRA, the regulator of securities firms.

Even when a mutual fund's portfolio is composed entirely of bonds, the fund itself has neither a fixed yield nor a contractual obligation to give investors back their principal at some later maturity date--the two key fixed characteristics of individual bonds, FINRA says.

In addition, because fund managers constantly trade their positions, the risk-return profile of a bond-fund investment is continually changing. A fund can increase or decrease its risk exposure at the whim of the manager. In this way, a bond fund is closer in character to a collection of equities than it is to that of individual bonds.

Here are some considerations:

1. Assess your risk profile. Different bonds and bond funds, like stocks and stock funds, carry different risk profiles. Generally, funds (and individual issues) pay out higher yields when the risk of default (an issuer missing an interest payment or failing to return the principal amount borrowed) is stronger. Investors are "paid" in higher yields for shouldering the increased risk. If bond funds are designed to meet a certain objective, managers may fold in riskier, higher-yielding bonds than an individual is comfortable with. That said, the experts' daring pursuit of yield across the bond spectrum may be beneficial, if appropriate to the investor's risk tolerance.

[See 5 Ways to Measure Investment Risk.]

2. Familiarize yourself with bond math. Yield and price move inversely. To calculate yield, subtract the price of the bond from the interest coupon. You should also read the bond's offering statement. That's where you will find a bond's important characteristics, from yield to the bond's call schedule. The call schedule tells you when an issuer might call the bond back, repaying the principal but ending the interest stream you've gotten used to.

3. Take a close look at the bond fund prospectus that a broker or the fund firm must provide. Not all bonds in a government bond fund are government bonds, for instance. Also, pay attention to fees. Individual bonds also have prospectuses, which derive information from a bond's indenture, a legal document that defines the agreement between bond buyer and bond seller. If opting for individual bonds, make sure your broker is experienced in fixed income, not just stocks. Check broker credentials and disciplinary history using FINRA BrokerCheck.

4. Ask your broker when, and at what price, the bond last traded. This will give you insight into the bond's liquidity (an illiquid bond may not have traded in days or even weeks) and competitiveness of the pricing offered by the firm, FINRA advises.

5. Understand all costs associated with buying and selling a bond. Ask upfront how your brokerage firm and broker are being compensated for the transaction, including commissions, mark-ups, or mark-downs.

6. Consider reinvesting coupons, or interest payments, right away in order to compound your returns. But plan ahead. It's a good idea to set up a "coupon account" at the outset if this is your intention. Bond funds automatically reinvest coupons.

[See 10 Great Dividend Stocks for 2012.]

Each year, fund tracker Morningstar compiles a roster of top bond fund managers. Reading some of the criteria behind the picks can help investors determine if those traits fit their own fixed-income investing philosophy. For example, the most successful managers seem to manage just the right mix of sticking to a disciplined approach but with just enough "risk taking" sprinkled in to make the fund do some heavy lifting. Manager resumes may go a long way toward raising your comfort level and helping determine if the costs and benefits of fund ownership are justified.

Last year was a true test of bond-fund manager mettle. Most pegged the treasury rally as finished a year earlier, only to watch the market soar again in 2011. Those managers who set themselves apart still managed some government bond exposure; their expertise, bucking conventional wisdom, paid off.

"Even among those active managers who were more sanguine about the Treasury market environment, few, if any, even maintained a fully neutral allocation to the sector, which comprised more than 34% of the Barclays Capital U.S. Aggregate Bond Index at the end of November," notes Eric Jacobson, Morningstar's director of fixed-income research.

As with any investing, homework should come first. Among select resources:

-- The government's TreasuryDirect provides educational information, as well as the opportunity to buy Treasuries online and over the phone.

-- The Investment Company Institute tracks bond fund inflows and outflows. The association also offers literature on bond mutual fund risks. Securities Industry and Financial Markets Association, or SIFMA, offers an Investing in Bonds education page.

See U.S. News's top-ranked taxable bond funds and municipal bond funds.

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