Bond Funds Own Bonds

Have you ever wondered whether it's better to buy your own bonds or to invest in a bond mutual fund? Are you unsure whether you should be buying a taxable and a tax-free bond fund? This week, I'll help you answer those questions.

This is part four in my Bonds 101 series. If you are just joining us or want to revisit one of the topics I’ve covered, here are the prior three installments:

At more than $45 trillion in total assets, the U.S. bond market is a big place, and we’ve covered a lot of ground. If I had to boil it down to just three key points, they would be:

  1. A bond is a contract—barring a default, you will know your cash flows and total return the day you purchase a bond.
  2. When choosing short- versus long-maturity bonds, the trade-off you are making is between price stability and income stability.
  3. High-quality bonds provide less income and are sensitive to changes in interest rates, but they’re better protection when stocks decline. Low-quality bonds typically generate more income and are less sensitive to interest-rate moves but they tend to drop in price when stocks sell off.

These three points form the foundation of my framework for understanding bonds, including how we should expect them to behave and the role they fill within a portfolio. I still need to talk about inflation, rising interest rates and the self-healing nature of bonds (and bond funds).

But first, I want to answer two common questions I get about bonds: How do I decide between taxable and tax-free bonds? And what’s the difference between owning a bond fund and owning a portfolio of individual bonds?

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