Bonds vs. Bond Funds

Daniel Penzing
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Return of Principal

When you purchase a bond, you are lending money to the bond issuer until the maturity date. The issuer agrees to repay you the face value of the bond at maturity, plus interest. Typically, the interest rate is fixed and the face value of the bond may be fixed or floating.

The most fundamental difference between a bond and a bond fund is in the source of the return you earn:

· A Fixed Income Bond Fund is an attempt to replicate the return of bonds. A portfolio of bonds is held to maturity with occasional changes made to the portfolio.

· A Variable Income Bond Fund attempts to earn the return of bonds by buying and selling returns of bonds.

· A Bond tries to earn interest income and repay principal back to you.

As such, there are four critical distinctions between a Bond and a Bond Fund:

  • · A Bond is simple to understand and manageable, has a fixed return that is easy to track and predictable;
  • · A Bond Fund is an investment and a portion of that investment has a fixed return that is easy to track and predictable, while the rest of the investment is invested in other assets to provide a stock-like variable return;
  • · The management of a Bond requires expertise in that field, management of a Bond Fund requires expertise in that field and expertise in the field of stocks;

Maturity Date

When you buy a bond, you are essentially borrowing money from the bond issuer. When you redeem the bond, they repay your initial deposit plus interest … just like you would a personal loan. The bond issuer will usually schedule the maturity date in the future. This gives you time to find the money to purchase the bond and for the bond issuer to find the best time to make the loan and receive the interest. Remember, this is a loan, so the issuer is paying you interest for your deposit … just like you would pay interest on a personal loan. The difference is that bonds will keep paying interest for a set number of years (typically years) until you redeem the bond or the issuer pays your principal.

Income

Income bonds are the most common and most well known bonds. Their values move in the opposite direction of their corresponding benchmark index or collateral. The higher the value of the index (or collateral), the lower the value on the income bond. The actual value of an income bond rises as the value of its corresponding index or collateral falls.

As an income investor, it is vital that you understand that income bonds are not "guaranteed," and therefore not as secure as money market instruments. If the issuer chooses to redeem the bonds before maturity, then you run the risk of not getting paid even though you continue to hold the bond until maturity

So, in order to make sure you are fully protected, it is important to stay aware of the issuer's credit rating, which can be found on ratings sites and on the issuer's own website. For example, let's say the issuer is downgraded from AAA to AA+ by Standard & Poor (S&P). That's a pretty big difference. If you sell the bond while it is still trading on the market, you might not get as full a return as you did when you first purchased it because investors now know that the issuer's credit rating has been lowered, which most likely means they are more likely to default on the debt related to those bonds in the future.

Diversification

Is great for your portfolio, but when is it too much?

Yes, diversification is a good thing. No one can argue that! When investing, diversification is crucial. Because without it, you are easily vulnerable to the risk of one or two investments going sour. You need a balanced portfolio that includes multiple investments. By diversifying, you have a better chance at reducing your risk.

But diversification works best when you are diversifying your portfolio outward rather than diversifying within your portfolio. That’s just a fancy way of saying that adding different types of securities to your portfolio is better than putting money into the same sector and different investments.

Too much of one investment within a balanced portfolio can be just as dangerous as having just one stock holding. A single company could get into financial trouble or go bankrupt. And in the end, it could tank your portfolio.

Therefore, even if you have a balanced portfolio, keep in mind that diversification doesn’t mean you need every single investment you own to be different. It means that you should reduce the investment that is putting your portfolio at risk.

Just as you should have no more than 10 percent of your cash invested in any one holding, you also should have no more than 10 percent of your investments in any one sector. Once you go beyond that, you run the risk of having something impact your portfolio in a negative way.

Liquidity

When you are investing in corporate bonds, there are 2 main types of returns that you can earn. First, you can earn interest payments on your investment and second, you can sell your investment for a profit.

To get paid interest, you will have to sell your bond back to the issuer of the bond. You can think of interest payments as a way of refilling your bond’s tank with fuel. Generally, you can only make interest payments from investments every 7 years. This is called the holding period.

Some bonds will let you sell your bond at any time. However, when you buy a corporate bond, you will want it to be a 1st lien (more senior) bond. This means that if the company goes bankrupt, the creditors will get paid back out of the assets of the company before the bondholders. Bonds are risky because they are tied to the fortunes of the company. When the company goes bankrupt, the bondholders are left with nothing. However, as the bondholders, you get paid before the secured creditors.

You can make a profit when the bond matures. You can also decide to sell your bond in the primary market as soon as it is trading. It is crucial that you sell corporate bonds before the holding period is up. Once the holding period expires, you no longer earn any interest and there is no way that you can refinance it.

Fees

How to Invest on the Cheap

Nothing will sink your retirement faster than high fees coupled with bad returns. Fortunately, there are plenty of ways that you can avoid that trap. This guide covers the two most popular ways to build your portfolio. Look below to see which investing vehicles remain the best of breed in 2017 and beyond.

Summary

If you are feeling overwhelmed by the idea of investing or trying to decide how to invest in bonds, you are not alone and there is no need for that. Many people feel that investing is out of their reach because it sounds too complicated or it is out of their comfort zone. This article will help you understand some of the basic concepts of investing and help you understand how you can apply these concepts to bonds.

What Is Investing?

Investing is using money to earn a greater rate of return than you would find if you left your money in a savings account or a money market fund.

There are a number of different types of investments you can make and they range from the safest to the riskiest. Bonds are medium risk investments.

If you want to find out more about investing, this article is a good place to start.

What Are Bonds?

For anyone not familiar with the concept of investing, bonds can seem very confusing at first. Are they stocks? How is that different than what I've already?

A bond is a debt. A bond certificate is simply a representation of a debt. You have loaned money to the government or a company and they have promised to repay you with interest.

How Do You Buy a Bond?