Bonds vs. Mutual Funds

Feb 10, 2022

Bonds vs. Mutual Funds: Here's What To Know

There are many options when it comes to investing. What should you choose? A savings account is where people start off, but it isn’t enough to secure a future or large spend goals.
Maybe you want to further your education or your child’s, or you have an eye on a house with that white picket fence? Or maybe you want to build wealth for a stress-free retirement.
To achieve long-term financial goals, you’ll want to look towards investments with high returns on investments. You will also want to keep a balanced, diversified portfolio. It’s not a good idea to allocate all of your resources to one security.
That is why we’d like to present bonds versus mutual funds to you. Learning about how each type of investment operates gives you the upper hand whilst managing your portfolio.

What Is a Bond?

Bonds take shape in the form of a loan. Government agencies and corporations use bonds to raise money. Investors purchase them to receive a predictable, fixed return.
There are both short-term and long-term bonds. Short-term bonds are three years or less. Long-term bonds are four years or more.
Their classification is set by their maturity date. This is the date the bond issuer is required to pay back the principal borrowed.

Types of Bonds

Here are five types of bonds:
  1. Treasury bonds
  2. Savings bonds
  3. Agency bonds
  4. Municipal bonds
  5. Corporate bonds
Treasury Bonds
As the name entails, Treasury bonds are issued by the U.S. Treasury Department. These are important as they set the stage for other types of bonds regarding the rate.
Treasury bonds are sold at auctions. They are also resold on secondary markets, such as the New York Stock Exchange (NYSE), Nasdaq, or the National Stock Exchange (NSE).
Savings Bonds
Also issued by the Treasury department, savings bonds are available to investors at an affordable rate. For as low as $25, these are primarily purchased from banks and credit unions.
There are two common types of savings bonds:
  1. I Bonds - adjusted for inflation approximately every six months
  2. Series EE Savings Bonds - earn interest at a fixed rate
Savings bonds accrue interest at a variable rate over time, with interest compounded semi-annually. They used to be sold in paper form; however, they are solely available electronically as of January 1, 2012.
Agency Bonds
Moving away from the Treasury department, agency bonds are issued by the Federal government or by government-sponsored enterprises (GSEs).
If you prefer to have an agency bond backed by a “full faith and credit of the U.S. government,” as the Treasury Department offers on savings bonds and treasury bonds, consider those issued by the Government National Mortgage Association, Ginnie Mae.
Other options that are not backed by a guarantee include the following:
  • Federal National Mortgage Association - Fannie Mae
  • Federal Home Loan Mortgage - Freddie Mac
  • Federal Agricultural Mortgage Corporation - Farmer Mac
There is a minimum when investing in agency bonds. The first is sold for approximately $10,000. Increments sold after cost approximately $5,000 each. These are paid on a semiannual basis.
Municipal Bonds
Often called munis for short, municipal bonds are issued by states, cities, or counties. How else do you expect capital projects (for example, schools and roadways) around your local area to be funded?
Investors in municipal bonds are promised regular interest payments and are returned the principal investment. The interest is typically paid semi-annually.
There are two types of municipal bonds to choose from:
  1. General obligation bonds are not asset-backed but guaranteed by “full faith and credit.”
  2. Revenue bonds - backed by the project revenues
Corporate Bonds
Instead of being issued by a government, corporate bonds are issued by a company. They function the same, paying interest to the investor and returning the principal when the bond matures.
Investing in corporate bonds provides growth potential to companies as they purchase equipment, refinance debt obligations, or initiate an acquisition or merger.
The largest risk associated with corporate bonds is bankruptcy. Should a company file for bankruptcy, a claim is issued against the company’s assets and cash flow. But remember, companies tend to have more than just bonds as a form of debt to pay back.

The Pros and Cons of a Bond

Here’s why you may want to consider adding bonds to your portfolio:
  • Bonds provide a fixed return. There is no guessing; you know what you’ll receive and when.
  • Bonds generally carry a low level of risk.
  • Bonds can earn more than a regular savings account issued from a bank
  • Bonds are rated by their risk level. This means you know ahead of time how much risk is at stake.
It’s also good to know why bonds may not be a good choice. Consider:
  • Overall return. Compared to other types of investments, the fixed return from a bond may not be as appealing as others.
  • Purchase price. Since bonds are used to fund projects, more than just a pretty penny goes into the initial cost. This can deter investors.
  • Defaults. Facing poor financial choices and bankruptcy are risks investors take.
  • Liquidity. This may not be a strong option if you are looking for cash quickly.
  • Interest rates. At the time of purchase, the interest rate is locked in. It may turn out to be favorable or unfavorable as time progresses.
  • Prepayment. As interest rates drop, a bond paying out a high coupon (interest rate) is likely to be  ‘called’ in for mandatory redemption earlier than the date of maturity by the issuer, leaving the bondholder no choice but to give up their higher yielding investment, while allowing the borrower   issue a new bond at a lower rate.

What Is a Mutual Fund?

A great analogy to describe a mutual fund is like a pot of stew. There is more than one ingredient used. They are combined into one pot and cooked together. When served, each bowl receives spoonfuls.
That is how a mutual fund operates. Mutual funds pool stocks, bonds, and other cash equivalents into one investment. Investors can then purchase shares of the pool to add to their portfolio.

Types of Mutual Funds

There are four main categories of mutual funds:
  1. Money Market Funds
  2. Bond Funds
  3. Stock Funds
  4. Target Date Funds
Money Market Funds
Money market funds date back to the 1970s. These tend to carry the lowest risk compared to other types of mutual funds.
Use money market funds to reach short-term goals or add to your emergency savings fund. Do not plan to reach a long-term retirement goal solely on this type of fund.
Bond Funds
This is a great alternative if you don’t have the lump sum of cash to invest in a bond. Bond funds invest in, you guessed it, bonds.
The most common type of bond fund is known as an open-ended fund. This type is actively managed as opposed to an index bond fund. Index funds are passively managed, tracking the activity of an index.
Stock Funds
Stock funds invest in stocks. They are also known as equity funds.
In owning a stock fund, you do not become a shareholder of the stock you are investing in. Instead, you are an owner of a bowl of stew.
Target Date Funds
As the name implies, a target date is set on a fund to gradually lower its overall risk. The date is typically associated with a future year, or the year of anticipated retirement.
Investing in target-date funds does not guarantee your return. Losses still can occur, and your savings goal may not be met.
For the best success, here are a few tips:
  • Select the date that aligns closest to when you want to retire
  • Monitor the performance of the fund
  • Check the overall allocation of the target date fund along with other investment portfolios
  • Assess the fees and expenses

Benefits of a Mutual Fund

Mutual funds offer:
  • Active Management - There is a professional behind-the-scenes observing the fund movement and re-balancing it as needed to maintain its performance objectives.
  • Diversification - Mutual funds focus on various industries, companies, and more to alleviate risk and optimize returns.
  • Liquidity - There is no maturity date or waiting period to redeem shares. Get your money when you need it.
  • Affordable Options - Initial investments won’t break the bank, nor do additional purchases.
  • Dividend Payments - Dividends earned on stock or interest are paid out to the investor, fewer expenses.
  • Capital Gain Distributions - At the time of sale, if the price is greater than the original purchase price, the change is distributed to investors, less any capital losses.

The Bottom Line

Bonds and mutual funds are two different types of investments. Both have their advantages and their disadvantages, as all types of investments carry.
Align your portfolio based on your investment goals. If you aren’t looking for cash now, bonds promise you a steady return over time. If you don’t want your money tied up but accessible, mutual funds meet your requirements.
Exchange-traded funds (ETFs) are another investment option for long-term growth. ETFs help to meet your real-life needs and save for the future.
Visit LifeGoal Investments to learn more about ETFs offered on the market to help you reach your financial goals and feel comfortable when investing.
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