Investing in bond ETFs, bond mutual funds or individual bonds

How they’re similar

• Bond ETFs and bond mutual funds both pool money from many investors and invest it in a selection of bonds or other debt investments, in line with the mandate of the ETF or mutual fund.
• Both charge management expense fees, expressed as a percentage of the average dollar amount of a fund investment known as a Management Expense Ratio (MER). This amount is not charged to you directly but is paid out of fund assets and is reflected in the fund’s return.

How they’re different

• As the name implies, bond ETFs trade on a stock exchange and you can buy or sell them any day while the stock exchange is open; regular ETF brokerage commissions apply.
• Mutual funds don’t trade on a stock exchange. Rather, they’re priced at the end of the business day and your order is filled at that day’s price, also known as net asset value (NAV). Mutual funds may have minimum investment requirements — check the fund description for details.
• Most ETF managers will publish a listing of their holdings daily, while mutual fund holdings are only available once a quarter. Less frequent reporting may make it more difficult to understand the current composition of the fund when deciding if it suits your investment requirements.

Active versus passive management

Although there are exceptions, bond mutual funds are typically actively managed while bond ETFs are typically passively managed. The fund or ETF description will usually make it clear which style is being employed. Let’s look at some key differences between funds that are actively and passively managed.

• For actively managed strategies, the manager seeks to outperform the benchmark index. They determine the portfolio composition and might underweight bond groups or individual holdings for criteria such as maturity date or credit rating.
• For passively managed strategies, the manager seeks to track the return of a specific benchmark, usually a bond index. This is accomplished by holding a group of securities that mirror the composition of the target index.
• Passively managed bond mutual funds are also known as bond index funds.
• If a bond ETF is actively managed, a common framework is to have the ETF track a benchmark index but allow the managers to deviate from the index, when and if they feel that’s appropriate.
• Passively managed strategies will typically have lower fees than actively managed strategies because they require less research and analysis, and possibly involve less frequent turnover of the portfolio holdings.
• Over time, and particularly in periods of very low interest rates, the higher fees of actively managed funds can have a greater impact on the investment’s returns.
• The higher turnover in actively managed investments can produce a higher tax liability for the investor. This may be important for you if you hold these products outside of a registered account.

Another alternative for bond exposure is to choose individual bonds. You decide what and when to buy and sell. When the bond matures, you can expect to receive your principal back, or you could sell it before maturity.

Investors who buy individual bonds can face different challenges than those who invest in bond ETFs or mutual funds. Here's why:

• Minimum investment amounts: many individual bonds have minimum investment amounts, which can typically range from $5,000 to $100,000 or more. This can make it difficult for an investor with a small portfolio to diversify their bond exposure across multiple issuers.
• Market liquidity: some individual bonds may not be very liquid, meaning it can be difficult to buy or sell them when you need to. This can make it harder for some investors to quickly respond to changes in the market and can affect the market price of the bond.
• Research: investing in individual bonds means you’ll need to do your own research and understand the creditworthiness of the issuer, the terms of the bond and other factors that can impact your investment. Although bond ETF and mutual fund choices should also be well researched, individual bond research is likely more complicated and requires advanced financial knowledge.

When your investment time horizon is no longer short term, your investments are more likely to feel the impact of economic changes during the time you hold them. Inflation and the health of the economy will likely fluctuate, and interest rates may move up or down. Looking globally, countries may be upgraded or downgraded, and companies will go through good and bad times. All these changes will affect bond prices, and longer-term bonds will often reflect them more dramatically.

Overall, with a longer time horizon, you’ll have more investing options to choose from, but your decisions may become more complicated. A longer-term allocation to bonds is not the “set it and forget it” proposition it might have been 50 years ago.