ETF Education

Individual Bonds vs. Bond Funds: A Comparison

What factors should you consider when selecting debt instruments for your bond core? And how can you gauge which ones align with your specific circumstances and investment goals?

12 min read

Bonds have an important role in a diversified portfolio — to generate income, preserve capital, and reduce overall volatility. Building a strong bond core involves investing in a range of debt instruments of various maturity dates, coupon rates, issuers, and credit ratings. You can do this by investing in bonds or bond funds — including bond mutual funds and bond ETFs.

So, what are each of these investment vehicles, and how do they compare?

Individual Bonds

Created when an issuer borrows money from a purchaser then makes periodic interest payments and agrees to pay back the face value at maturity.

Bond Mutual Funds

Mutual funds pool individual bonds into a fund. Shares can be bought from the fund sponsor or through a broker.

Bond ETFs

Like bond mutual funds, bond ETFs pool individual bonds into a fund. Shares can be bought on the stock exchange.

Individual Bonds

Bonds are debt instruments that typically have a fixed principal value, often referred to as the face or par value. Bonds usually pay interest or coupon payments until the date of maturity, usually semiannually.

Investors can purchase individual bonds directly from the issuer or buy and sell them on the secondary market for a price determined by the market. Factors like prevailing interest rates, remaining coupon payments, and time to maturity impact this market price. Bonds are classified based on:

Terms of Purchase

Since bonds are issued to borrow money, they have defined terms of purchase, similar to a loan from the bank. A bond’s price, coupon rate, and maturity date are determined at the time of purchase, allowing investors the ability to determine a bond’s value in the secondary market.

Type of Issuer

Bonds are classified based on their issuers. For example:

Corporate bonds are issued by companies as an alternative to taking a bank loan to raise capital.
Municipal bonds are issued by states and municipalities; their income is commonly tax free at the federal level, but may be taxed at the state level.
Government bonds are issued by the US Treasury and are further divided based on their maturity date (less than a year, 1 to 10 years, and over 10 years).
Agency bonds are issued by government-affiliated agencies and can be viewed as a subcomponent of government bonds given that some are guaranteed by the government (e.g., mortgage backed securities issued by the Federal National Mortgage Association)
Foreign bonds are issued by global corporations and governments.

Investment Grade

Grades represent the creditworthiness of bonds based on the issuer’s capacity to meet its financial obligations. These grades are issued by credit rating agencies like S&P, Moody’s, and Fitch. Bonds are broadly grouped as investment- or speculative-grade based on the associated risk.

The relationship between these different characteristics and market conditions impacts the risk and returns of bonds.

Benefits of Investing in Individual Bonds

The nature of individual bonds makes them attractive investment options for some investors. Their potential benefits include:

Control and Transparency: Since bonds have defined coupon rates, face values, and maturity dates, investors have better oversight over the cost, return on investment, and tax implications.
Research and Oversight: It’s easy to align bonds with your investment goals as you can invest based on your risk appetite, duration preference, and desired rate of return. Using individual bonds also gives you greater flexibility to reposition your portfolio based on market conditions and prevailing interest rates.
Predictability: Since bonds have defined returns, investors looking for regular income may prefer purchasing bonds for their relatively more predictable income stream and return of principal at maturity.
No Additional Expenses: Investors purchase bonds directly, so there is no additional management fee.

Drawbacks of Investing in Individual Bonds

Individual bonds also have some drawbacks that investors need to keep in mind, like:

Lower Frequency of Income: Usually, bonds provide returns semiannually. Therefore, those relying on bonds for stable income need to actively manage the income generated from bonds.
High Cost: Bonds are generally priced higher than bond funds, which can make them prohibitively expensive at times for retail investors.
Diversification Is Harder to Achieve: Diversifying your bond portfolio involves investing in multiple bonds and laddering them to ensure the availability of funds at different times and to minimize concentration of funds. Since the cost of individual bonds is higher, investors need to invest more of their capital in bonds to diversify their bond portfolio.
Lose Out on Institutional Investor Pricing: Since institutional investors tend to buy bonds in large quantities, they often receive more favorable rates than retail investors when purchasing bonds. This works to reduce the cost of the bond.
Research- and Management-intensive Process: The bond market is considered more complex than that of equities given its fragmented nature with thousands of different bonds that span a wide range of maturities, coupons, and credit ratings. For example, the Bloomberg US Aggregate index includes over 13,500 issues and the Bloomberg US Municipal index includes 58,476 issues.¹

Understanding which bonds in which combination will help you achieve your investment objective takes a lot of research. Additionally, you need to manage the reinvestment of interest and principal after maturity.

Bond Funds

Bond funds — both bond mutual funds and bond ETFs — buy a large number of different types of bonds that are diversified based on the objective of the fund. The bonds are then pooled together into a fund, and fund shares are offered to investors. The interest received on the bonds is distributed to the fund’s shareholders or reinvested into the fund.

Funds can be indexed or actively managed. Indexed funds attempt to track the composition and performance of the underlying bond index. Actively managed funds are managed by financial professionals who invest based on what they think are the best opportunities available, keeping in mind the fund’s investment goals.

Both indexed and active funds are characterized by:

Defined Fund Structure

Bond funds pool resources from many investors who invest in a bond fund based on factors such as the fund’s objective, the expense ratio, the index it tracks, whether it is active or passive, and whether returns are distributed or reinvested.

Closely Following Market Conditions

The NAV of bond funds is impacted by market factors like changes in prevailing interest rates. This is especially true of bond ETFs that may trade at a premium when interest rates rise or at a discount when rates fall.

Professional Management

Funds are professionally managed where investors can evaluate funds based on factors like the fund size, credit quality, portfolio manager/fund family philosophy and style, and historical performance.

Benefits of Investing in Bond Funds

Bond funds offer many advantages due to their structure.

Consistent Income: A bond fund can provide a consistent stream of income or reinvestment opportunities depending on the investor’s preference and the fund’s goal.
More Cost-effective and Accessible: On average, the minimum investment requirement of bond funds is much lower than the average cost of a bond. Thus, bond funds allow you to build a diversified bond portfolio without having to allocate more capital than you’d like.
Liquidity: Bond mutual funds offer daily liquidity. Investors can redeem, partially or completely, the fund shares they own; the trades typically execute on the next trading day, after market close. Bond ETFs take this a step further by offering intra-day liquidity, as you can sell bond ETFs on the exchange like stocks and receive the sale proceeds immediately. However, remember that the sale of shares in a fund may result in a capital gain or loss.
Diversification for Lower Cost: Since funds pool a large variety of funds and shares of a fund cost less than individual bonds, on average, it may be more cost effective to create a well-rounded bond portfolio with just a small number of funds. In other words, you can achieve greater diversification per dollar invested.
Less Intensive Research: Comparing the performance of bond funds and their managers can be a lot less time consuming than comparing individual bonds across a variety of criteria. Moreover, instruments like high yield bonds, bank loans, and preferred securities have many nuances that may be hard to understand completely.
Institutional Pricing: Since institutions buy bonds in large quantities, they may get better pricing.

Drawbacks of Investing in Bond Funds

But bond funds are not without disadvantages.

Potentially Less Control and Transparency: Though most bond funds have clearly stated objectives, guardrails, and methods provided as part of the fund’s prospectus, fund managers are free to invest in whatever bonds they feel present the best opportunities as long as the purchase aligns with the parameters established in the prospectus. To provide transparency, funds publish their complete holdings periodically. Mutual funds often publish complete holdings a few times a year, while many ETFs disclose their complete holdings daily.
Management Fees: Part of the money you invest in bond funds goes toward management fees, a cost that is not present when purchasing individual bonds. If these fees are unreasonably high or higher than prevailing market standards, they can eat into your returns. Thus, evaluate the total expense ratios (TER) of funds before deciding to invest in them, especially when comparing bond funds and bond ETFs. Bond ETFs cost 58% less on average than their mutual fund peers.²
NAV Market Fluctuations: The NAV of bond funds is impacted by prevailing market interest rates. This is because as new bonds are issued with higher or lower interest rates, it inversely impacts the price of older bonds on the secondary market. Thus, bond funds exhibit more volatility in their performance when interest rates rise or fall in comparison to bonds that are held until their maturity date.
(Hidden) Tax Consequences: It is harder to estimate the tax impact of capital gains distributions in bond funds and plan for them as investors don’t have visibility into the gains at the fund level.

Using Bond ETFs for a Balanced Bond Portfolio

Bond ETFs have grown in popularity since they launched more than 20 years ago. As of April 30, 2024, there are over 680 bond ETFs that help investors target a variety of investment goals (Figure 1). Their many benefits over bond mutual funds make them an attractive option for constructing the bond component of your portfolio.

More Transparency: Many bond ETFs publish their complete holdings at the end of every trading day, allowing investors to monitor how closely the fund is tracking an index (in the case of index funds) or aligning with its stated investment objectives.
Intraday Liquidity: Since bond ETFs can be traded like stocks, they can be liquidated at any time during a trading day, making them much more liquid than mutual funds.
Laddering Opportunities: Some bond ETFs target specific maturity periods, allowing investors the opportunity to use ETFs to build bond ladders rather than using individual bonds.
Lower Expense Ratios: The average net expense ratio of bond ETFs is 0.35% while that of bond mutual funds is 0.83%.³Bond ETFs are generally the more cost-efficient instrument for gaining exposure to bonds.
Greater Tax Efficiency: Investors have more control over taxes with ETFs given they are more tax efficient than bond mutual funds, which may have hidden tax consequences and thus complicate tax planning.

Individual Bonds vs. Bond Funds: A Comparison

Characteristics	Individual Bonds	Bond Funds
Purchasing cost	Investors pay a one-time commission or an annual fee and individual transaction charges.	Investors pay a sales fee. Additionally, there may be an annual management fee.
Diversification and minimum investment price	Achieving broad diversification requires investors to buy a wide variety of bonds which requires a greater amount of capital. The total cost of diversifying with individual bonds can be much more than that of bond funds.	Broad diversification can be achieved with one or a few funds as funds pool hundreds of bonds and offer shares.
Liquidity	Different bond types have different levels of liquidity — Treasurys and certain corporate bonds are more liquid but municipal bonds tend to be less liquid.	Bond funds are highly liquid as shares in a fund can be sold at any time. Bond mutual funds execute transaction at the end of the following trading day and bond ETF transactions are executed on the exchange in real time.
Return predictability	Returns are more predictable. Especially for bonds held until maturity, investors know the principal and returns they will receive, barring situations where the issuer defaults.	Since the NAV of funds fluctuates based on market conditions, the market value at maturity is unpredictable.
Principal protection	Investors know the par value of the bond that will be returned at maturity subject to the credit worthiness of the issuer.	Since bond funds don’t mature and their NAV changes daily, there is no certainty about the principal sum invested being recouped at the time of sale.
Tax implications	Investors will need to pay capital gains taxes if the bond is sold for a profit prior to the maturity date.	Investors pay capital gains taxes when they sell shares they own for a profit. Additionally, funds pay capital gains taxes when the fund manager sells bonds held by the fund for a profit and this cost is passed on to investors. Investors also may be taxed on gains even if they have not redeemed their shares.
Level of control and transparency	As investors carry out transactions themselves, they have complete oversight and control over transactions and tax implications are fully known.	Apart from providing the objective, guardrails, and methods of the fund, fund managers also provide information about the complete holdings of the fund periodically, including the cash being held for administrative needs and from redemptions. However, investors don’t have control over investment decisions or their tax implications.
Research and oversight	Investors need to undertake a lot of research to understand which bonds they should combine to create a broad and balanced bond portfolio that helps them achieve their investment objectives.	Investors need to compare funds to see which best suits their investment objectives.
Income frequency	Most bonds make coupon payments semiannually — either in January and July or in March and September.	Funds offer options to reinvest or receive income and generally offer monthly distribution of income in the form of dividends.

Key Takeaways: Individual Bonds vs. Bond Funds

So, is it better to buy bonds or a bond fund?

Buying individual bonds offers control, transparency, better oversight, and better principal protection, but requires more research and capital investment.

Bond funds offer more liquidity and diversification without the need for investing a large amount of capital, time, and management expertise.

That’s why many investors and portfolio managers build their bond allocation with bond mutual funds and ETFs.

Individual Bonds vs. Bonds Funds: Deciding Which Is Right for You

Whether you invest in bond funds or individual bonds, or a mix of both, depends on your circumstances and goals. Ask yourself these three questions to guide your decision:

How much capital do I want to allocate to bonds? The amount you want to invest affects how you build your bond portfolio.
What are my financial goals? Your investment timeline, reinvestment/income needs and risk appetite all impact how you combine and ladder your bonds and bond funds.
How much time and effort do I want to spend on research and management? Professional fund managers reduce the amount of time you need to spend on your portfolio.

How can bond ETFs help you achieve your investment goals?

Start Exploring

Footnotes

Glossary

Disclosures

Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.

Diversification does not ensure a profit or guarantee against loss.

Investing involves risk, including the risk of loss of principal.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.

The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.

The gross expense ratio is the fund’s total annual operating expenses ratio. It is gross of any fee waivers or expense reimbursements. It can be found in the fund’s most recent prospectus.

ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns.

The S&P 500® Index is a product of S&P Dow Jones Indices LLC or its affiliates (“S&P DJI”) and have been licensed for use by State Street Global Advisors. S&P®, SPDR®, S&P 500®,US 500 and the 500 are trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”) and has been licensed for use by S&P Dow Jones Indices; and these trademarks have been licensed for use by S&P DJI and sublicensed for certain purposes by State Street Global Advisors. The fund is not sponsored, endorsed, sold or promoted by S&P DJI, Dow Jones, S&P, their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of these indices.

Investing involves risk including the risk of loss of principal.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.

All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

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