You will have spent some time in the past discussing with your financial adviser direct vs indirect investing in the three components of your portfolio. Indirect investing in your bond portfolio means buying mutual funds to achieve your goals. Direct means buying the bonds yourself, and “cutting out the middleman”. Here are the pros and cons of each:

Term to Maturity

Direct Investing

Mutual Funds

Each bond you own will have its own maturity date, at which time you will receive back your money, either to spend or re-invest. While each bond that a fund owns has a maturity date, the fund as a whole has no maturity date. You must sell some units to receive back capital.

Safety of Capital

Direct Investing

Mutual Funds

The credit risk is dictated by the borrower that you choose to lend to: various levels of government, various qualities of corporations — with “junk bonds” at the bottom.If you lend to high quality borrowers and hold the bond to maturity, your safety of capital is completely guaranteed.Through the holding period, the market value of the bond will fluctuate and reflect an unrealized gain or loss, which can either be realized by selling it, or ignored by holding it until it matures. The credit risk is dictated by the fund manager and the policy of the fund. Some bond funds invest strictly in government issues or in corporate issues. Some have a mix and some invest specifically in high-risk borrowers.The fund prospectus, or information in business newspapers, will tell you what the fund strategy is.At any point in time, a bond fund is likely to have an unrealized capital gain or loss. Thus, selling your units likely will generate a gain or loss from your initial investment.

Income Stream

Direct Investing

Mutual Funds

You can buy bonds to suit your cash flow needs. Mortgage-backed securities pay monthly, regular bonds typically pay semi-annually (some are annual) and strip bonds defer all interest payment until maturity.By building a portfolio of semi-annual pay bonds that have different payout months, you can have income cash flow every month. If you don’t require the income to spend, the bits of interest must find a means to be re-invested into your portfolio. Bond funds typically distribute interest income monthly or quarterly and any capital gaines annually. You can choose to have the distributions received in cash or re-invested in more units (“DRIPs”).

Market Liquidity

Direct Investing

Mutual Funds

Bonds can be sold and converted into cash in 3 days. Bond funds can be sold and converted into cash in 3 days.

Minimum Investment

Direct Investing

Mutual Funds

Bonds come in minimum face values of $5,000. Thus, for interest-paying bonds, the minimum out-lay will be very close to $5,000, plus accrued interest.Strip bonds, however, sell at discount and thus, depending upon the term to maturity, can be purchased for as little as $2,500. Very long term bonds can be purchased for under $1,000. The minimum is usually $1,000 but can be as low as $500.

Cash Calls

Direct Investing

Mutual Funds

You can build your bond portfolio so that principal amounts mature on a schedule to suit any cash calls you have. The minimum likely would be $5,000 and further amounts would be in $5,000 increments.Unscheduled cash calls would require selling a bond into the market prior to maturity, and ma generate a capital gain or loss. As a bond mutual fund does not have a maturity date, any cash calls, scheduled or un-scheduled, must be funded by selling units. There is no minimum or maximum.

Capital Gain/Loss Potential

Direct Investing

Mutual Funds

When you buy the bonds yourself, you control the average term-to-maturity and the credit risk. You also control the decision to hold to maturity (eliminating capital gain or loss potential) or selling it prematurely to realize a gain or loss. Selling prematurely forces a re-investment decision. At any point in time, a bond fund is likely to have unrealized capital gain or loss. The exposure to this is driven by the “average term-to-maturity” of the fund and credit risk, which is controlled by the fund manager and can be determined in either the fund prospectus or the business newspapers.

Rates of Return

Direct Investing

Mutual Funds

You control the long-term return by choosing the spread of maturities and credit risk of borrowers. You control the day-to-day return by either holding to maturity or actively trading your bonds for capital gains. The fund manager directly controls all of these issues. You control it indirectly and somewhat by choosing the particular funds. Bond fund returns are net of “MER” to the fund company of, on average, 1.7%.

Tax Efficiency

Direct Investing

Mutual Funds

You control the portfolio’s exposure to capital gains/losses and thus have a higher degree of control over tax issues. In a non-sheltered account, capital losses generated by the fund may not have tax value for a particular investor.