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?
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?
1
Individual bonds
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.
2
Bond mutual funds
Bond mutual funds
Mutual funds pool individual bonds into a fund. Shares can be bought from the fund sponsor or through a broker.
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:
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.
Bonds are classified based on their issuers. For example:
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.
The nature of individual bonds makes them attractive investment options for some investors. Their potential benefits include:
Individual bonds also have some drawbacks that investors need to keep in mind, like:
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—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:
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.
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.
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.
Bond funds offer many advantages due to their structure.
But bond funds are not without disadvantages.
Bond ETFs have grown in popularity since they launched more than 20 years ago. As of May 31, 2025, there are over 800 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.
| 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. |
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.
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:
Learn more about bond ETFs and how they can help you generate income, preserve capital, and manage risks.
