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Should I Own Bonds? Or Are Bond Funds Better?

With shorter-term interest rates on the rise and stocks causing whiplash these days, fixed income investments are suddenly back in vogue. While this catch-all phrase also includes Certificates of Deposit (CDs) and other financial instruments, most investors seek out income from bonds and bond funds.

But are bond fund, or bonds themselves the better choice?

Before we answer that question, know that the interest rates on shorter-term bonds (and funds) are influenced by Federal Reserve policy. Yields on longer-term bonds are impacted by inflation and economic trends. Also, note that a bond’s value (i.e. its price) moves in the opposite direction of interest rates. As the Fed has been hiking rates, short-term bonds are producing better yields (but losing value) while longer-term bonds have seen their yields shrink (and their prices rise).

What matters is where things stand today, not yesterday. Bonds (and bond funds) are an important source of diversification and are a key ingredient in a balanced portfolio. And they no longer sport insultingly low yields.

If you buy an individual bond that is issued by a corporation, the U.S. government or a state or local municipality, you should likely plan to hold on to it for the life of the bond. Trading individual bonds can be a bit burdensome. By owning them until maturity, you really don’t need to pay attention to the direction of interest rates, at least until it’s time to re-invest the proceeds.

Bond funds are a great vehicle for people that want to have a more limited exposure in terms of timeframes, with the freedom to quickly cash in if a home purchase or other financial needs arise. But bond funds can lose value when interest rates rise, which can offset any income you may glean.

Also, it pays to compare fees. You’ll pay a modest one-time sum to buy (or sell) a bond. In contrast, bond mutual funds can charge an annual management fee that is typically around 0.75%, according to Morningstar. As with any kind of fund, exchange-traded funds (ETFs) are usually far cheaper than mutual funds. The average fee for a bond ETF is around 0.33%. Please stop buying mutual funds.

In sum, bond ETFs may be the best bet. There are a broad range of them to choose from, enabling you to glean very targeted exposure to just one slice of the bond market. And the ability to change your bond exposure as the economy and interest rates change is something you won’t get from a buy-and-hold strategy.