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Investing

March 21, 2014

Bonds vs Bond Funds

Investing in bonds (either directly or in a bond mutual fund) can help broaden your investment portfolio.

Bonds

A bond is a loan. When you buy a bond, you are lending money to the issuer of the bond — be it a government or a company. The issuer undertakes to pay you interest at fixed intervals (the “coupon”) for a set term and repay your principal when that term is up (that is, the bond matures). So, if you buy and hold, you get your money back, plus interest.

“It removes some of the uncertainty that comes with investing,” says Andrew Allentuck, author of Bonds for Canadians: How to Build Wealth and Lower Risk in your Portfolio.

Of course, it doesn’t eliminate all uncertainty. As in life, you must choose to whom you lend money with care: Borrowers do sometimes default on their loans. But if you buy a bond issued by a stable government such as Canada’s, you are almost certainly going to have your capital returned at the end of the bond’s term, as well as receive regular interest payments along the way.

The same principle applies if you buy a bond issued by a company. You want to be sure that the company has the cash flow and track record to repay your capital plus interest. (Be particularly cautious of bonds offering high interest rates, known as “high-yield” bonds; the issuer may be offering a higher coupon because its financial situation may not allow it to attract buyers at a lower interest rate.) Another consideration: Corporate bonds can be issued with various covenants and conditions that you want to be sure you understand.

You can sell your bond before it matures, but that introduces yet another element of risk. Bonds have an inverse relationship to interest rates. If interest rates are up and bond prices are correspondingly down, you may end up selling your bond for less than you paid for it. On the other hand, if interest rates are down, you may be able to sell your bond at a premium.

Bonds, however, do not trade on an investor-friendly exchange the way most stocks do. Getting current bond prices requires a little more research, such as looking them up through a broker. As Christopher Davis, director of fund analysis at Morningstar Canada in Toronto explains, there is less transparency of pricing.

Bond funds

If you’re not prepared to do the research required to buy bonds directly, investing your money in a bond fund — a type of mutual fund that focuses on bonds rather than stocks — may make sense. You are putting your cash into the hands of a professional money manager who follows economic conditions and interest rates and who diversifies the fund’s holdings across a number of bonds. That raises the possibility that the fund will return more than buying a bond directly.

Taxes are also a factor. If you buy bonds directly, your coupon payments are taxed as interest income. If you sell the bond before it matures, your gain — or loss — is subject to the lower taxes payable on capital gains. A capital gain or loss will also apply if you hold a bond to maturity, but originally purchased it for a price other than its face value. On the other hand, if you hold bonds within a registered account, taxation is deferred until you withdraw money from that account.

Should you buy bonds or bond funds?

Whether to buy bonds directly or hold a bond fund depends on your financial needs, your tolerance for risk, the size of your savings, even your tax situation.

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