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Bonds vs. bond funds

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POSTED: August 7, 2008 5:00 a.m.

As an investor, you may find that bonds can be a valuable part of your portfolio. But choosing to invest in bonds is one thing — and choosing how to invest in them is another. Basically, you’ve got two choices: individual bonds or bond-based mutual funds. Which approach is right for you?

There’s no one right answer for everyone. So let’s review some of the common reasons for investing in bonds and see how they are addressed by individual bonds and by bond funds:

Diversification — By investing in bonds, you can help diversify a portfolio that may be dominated by stocks. (Keep in mind, though, that diversification, by itself, cannot guarantee a profit or protect you against a loss in a declining market). While individual bonds can help diversify your holdings, you may be able to achieve broader diversification by investing in a bond fund, which may own a mix of corporate and government bonds.

Fixed rate of return — When you buy an individual bond, you receive a fixed interest rate and predictable interest payments. Until your bond matures, or unless it is "called" (bought back) by the issuer, you will always receive the same rate of return. But a bond fund does not pay you a fixed rate of return; instead, you receive dividends, which will fluctuate, based on the underlying bonds’ interest rates and capital appreciation.

Return of principal — If you buy an individual bond, you will get your principal back when the bond matures, provided the issuer doesn’t default. (However, before the bond matures, its value will rise and fall, based on current market interest rates.) Bond funds do not mature and have no obligation to return your principal, so you could lose some or all of your initial investment when you sell your shares which is based on current market values.

Costs – You can invest in most types of bonds for a relatively small fee or commission. But if you buy a bond fund, you will be subject to the same types of charges — such as sales charges, management fees and service fees — that are attached to many types of mutual funds.

Taxes — When you own individual bonds, you’ll pay current income taxes on your interest payments, but you won’t be subject to capital gains if you hold your bonds until they mature. However, if you purchase bond funds, you could be subject to capital gains taxes in two different ways: if you sell your fund shares for a profit or if the fund manager sells an underlying bond for more than it’s worth. If that happens, the capital gain — and the tax obligation — will be passed on to you. This increased capital gains liability is one reason that many people put bond funds in a tax-deferred vehicle, such as an IRA or a 401(k).

Before investing in a bond or bond fund, consult with your financial advisor to see which vehicle is appropriate for your needs. Also, before purchasing a bond fund, read the prospectus carefully. The prospectus contains more complete information, including the funds investment objectives, risks, charges and expenses as well as other important information that should be carefully considered before you invest or send money.

By getting the help you need, and by doing some homework on your own, you can find the bonds or bond funds that can help you make progress toward your key financial goals.

Submitted by Laura Evans, a financial advisor with Edward Jones in Richmond Hill.

 

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