A common misunderstanding about investing in bonds or bond mutual funds is that there is no risk to principal. This is not the case.
Interest rates are currently at historically low levels. If interest rates rise, bond prices would fall, and so too could the net asset values of some bond mutual funds. Returns can also decline if investors choose to move their money elsewhere and force fund managers to sell the bond holdings at a loss to pay redemptions.
Individual bonds and bond funds are two very different animals. Understanding how bond funds and individual bonds differ will help you assess which is the best investment option for you. Here are four factors you should consider:
Return of Principal. Unless there is a default, when an individual bond matures or is called, your principal is returned. That is not true with bond funds. Bond funds have no obligation to return your principal. Generally, bonds funds do not have a maturity date. With a bond fund, the value of the investment changes from day to day. The value of Individual bonds trading in the secondary market also change from day to day, but if the price of a bond declines below par, investors can hold the bond until it matures and collecting the principal, unless there is a default by the issuer.
Diversification. Generally, investors obtain greater diversification through a bond fund. This diversification can be obtained at lower investment of capital and lower costs than buying individual bonds. To create a diversified portfolio of individual bonds, investors need to purchase several bonds, and that might cost you tens of thousands of dollars. Most mutual funds only require a minimum investment of a few thousand dollars.
Income. With most fixed-rate individual bonds, the interest amount to be paid is stated in the bond offering. With bond funds, the interest amount distributed will fluctuate with changes to the underlying bond portfolio. Bond funds tend to pay interest monthly whereas most individual bonds pay interest semiannually.
Liquidity. Generally, all bond funds can be sold easily at anytime at the current net asset value of the fund. The liquidity of individual bonds, on the other hand, can vary considerably depending on the bond. In addition to taking longer to sell, illiquid bonds may also be more expensive to sell.
Investing in fixed income oriented investments, like individual bonds or bond funds, has risks that should be explained to the investor. Just because an account or an individual investment has decreased in value does not necessarily mean that a financial adviser has acted inappropriately. At Crary Buchanan, we provide consultations concerning negligence arising from improper financial advice. We invite you to call us to discuss your rights and remedies under the law.