Bonds vs. bond funds: Pros, cons & key differences

Investing means making choices, and that's where a deeper understanding of your options can pay off. Individual bonds and bond funds are a good example. While both are fixed-income investments, their structures and dynamics differ significantly. Let's take a closer look at bonds vs. bond funds, including their benefits and drawbacks, so you can determine if one or both would be a fit for your investment portfolio.

Bonds are debt securities that represent a loan made by an investor to a borrower (typically a corporation or government entity.) When an investor buys an individual bond, they are essentially lending money to the issuer in exchange for periodic interest payments and the return of the principal amount at the bond's maturity.

Bonds are considered fixed-income securities because they provide a fixed, predetermined stream of income to the bondholder.

• Dive deeper: Bond terminology: What to know before you invest

Bond funds, also known as fixed-income funds, are investment funds that pool money from multiple investors to invest in a diversified portfolio of bonds. These funds, which may be mutual funds or exchange-traded funds (ETFs), are overseen by professional fund managers. They offer investors exposure to a broad range of bonds without having to purchase individual bonds directly.

Bond funds can provide diversification, income and professional management, making them attractive to a wide range of investors.

As you consider if bonds or bond funds are right for you, take note of these six core distinctions:

Individual bonds represent debt securities issued by a government, municipality, corporation or other entity. Each bond has a fixed maturity date, a face value and pays periodic interest to the bondholder.

By contrast, bond funds are investment vehicles that pool money from multiple investors to invest in a diversified portfolio of bonds. Investors in bond funds own shares of the fund, not the individual bonds within the portfolio.

Investors in individual bonds must actively manage their own portfolios, including selecting bonds, monitoring credit quality and making decisions about holding or selling.

Bond funds are managed by professional portfolio managers who handle the selection and rebalancing of the underlying bond portfolio. The cost of professional management is included in the fund's expense ratio.

Purchasing individual bonds can require a substantial amount of capital as bonds often have minimum face values such as $5,000 or higher, and building a diversified bond portfolio may be cost-prohibitive for smaller investors.

Bond funds, on the other hand, are accessible to investors with smaller amounts of capital. Investors can buy shares of the fund at the prevailing market price, so this makes them more suitable for a broader range of investors.

Investors may incur transaction costs when buying or selling individual bonds, and holding bonds may involve custody fees.

Investors in bond funds pay expenses in the form of a management fee or expense ratio. These fees cover the costs associated with managing the fund. These fees typically are lower than the costs of managing a diversified bond portfolio independently.

With bonds, you get limited customization. You choose individual bonds from the pool of available bonds based on issuer, maturity and coupon rate.

Bond funds are more customizable, allowing you to select funds based on specific criteria like credit quality, maturity range and sector exposure.

Bond investors need to actively manage their own diversification by selecting a variety of individual bonds with different issuers, maturities and credit qualities.

Bond funds, however, can inherently provide diversification because they hold a large basket of bonds. These investors gain exposure to a diversified bond portfolio through a single investment in the fund.

The choice between investing in individual bonds or bond funds depends on your financial goals, preferences and risk tolerance.

• Diversification. Bond funds offer immediate diversification across a variety of bonds without the need to manage a portfolio of individual securities.

• Professional management. If you prefer professional management and do not want to actively select and monitor individual bonds, bond funds can provide a solution. They're managed by professionals who make decisions based on market conditions and economic trends.

• Liquidity and accessibility. If you value the ability to buy or sell shares on the open market throughout the trading day, bond funds have the advantage. They provide more immediate liquidity compared to individual bonds.

• Portfolio customization. Investing in individual bonds enables more control over the composition of your bond portfolio, with the ability to select specific bonds, maturities and issuers. Just keep in mind, they may be limited by minimum investment or face amounts.

• Income stream control. If you want more control over the timing and size of income payments, individual bonds may be attractive. They provide fixed interest payments at specific intervals.

• Interest rate environment. In a rising or high interest rate or inflationary environment, individual bonds allow investors to hold securities until maturity, potentially mitigating the impact of interest rate fluctuations.

Diversification, professional management, liquidity needs and risk tolerance are key factors to consider when weighing bonds vs. bond funds. For example, if you have a long-term investment horizon and are looking for stability and income, individual bonds might be more suitable for you. For shorter-term goals or more active management, bond funds could be a better fit. Some investors may benefit from holding both bonds and bond funds in their portfolios.

Consulting with a financial advisor can help guide you in the right direction for your unique needs.