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Bonds vs. bond funds

by | Jan 22, 2012 | OTHER, SELF-PUBLISHED

Q – I am a fixed-income investor, and I require income from my investments. I have been looking to invest directly in bonds vs. bonds funds. What are the risks of investing in a bond? – Robin S., Forest, Ontario

A – All investments, including bonds, offer a balance between risk and return. The risk is simply the chance that you will lose some or all of the money you invested. The return is the money you stand to make on the investment. But there is no free lunch: The more risk, the higher the return; the less risk, the lower the return.

Bonds are characterized as fixed-income investments, which typically carry lower risk then an equity investment. When you purchase a bond, you are promised the face value or the amount you originally invested at the maturity date of the bond. The bond pays you an annual interest rate, known as the “coupon rate.”

There are many types of bonds available, from government bonds to high-yielding corporate “junk” bonds, and each carries different types of risks. Some risks associated with bonds include interest rate risk, reinvestment risk, inflation risk, default risk, and credit rating risk. It is important that you understand each of these risks before investing in the bond market.

When you are comfortable with the associated risk, be sure to only buy bonds that have been rated AAA or AA by one of the big bond rating agencies. If safety of capital is your ultimate goal, then stick to federal government-issued bonds, or “Canadas.” (Note that Canada Savings Bonds are not “bonds” in the true sense, as they cannot be traded on the open market. In this respect, they are more like liquid term deposits.).

Pure bond funds, such as those found primarily in the Canadian Fixed IncomeGlobal Fixed Income, and High Yield Fixed Income categories offer a wide range of risk levels, maturities, and yields. Some are actively managed, while others, like exchange-traded funds, passively track indexes. One advantage of a bond fund is that it’s economical. You get exposure to a range of bonds of your choice while taking advantage of the economies of scale that funds can offer on trading costs – it’s impossible for individual retail investors to get a favorable spread from a bond dealer on smaller bond purchases. Bond funds trade in tens or hundreds of millions of dollars in face value every day and are thus able to get far better rates from dealers than individual investors.

I strongly believe that bonds should play a role in virtually every investor’s portfolio. And most of us will use bond funds of some sort to get that exposure. But you need to do your homework. So why not start with Fundata analyst Brian Bridger’s recent article on bond funds in the Fund Library? –R.T.

© 2021 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

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