An investor who is interested in gaining exposure to fixed-income investments, which are bonds, has the option to invest in mutual funds or individual securities. By investing in mutual funds, an investor gains the advantage of having a portfolio managed by a professional. Mutual funds might also contain other financial securities, such as stocks. Investors who purchase individual fixed income securities are taxed differently than mutual fund investors.
Bonds are a type of debt in which an issuing entity borrows money from investors. Investors are repaid with continuous interest payments for the life of a bond and with the subsequent repayment of the principal amount of the investment when the contract expires. Mutual funds can contain a number of different securities. Professional managers use pooled assets of multiple investors to buy and sell financial securities, including stocks and bonds. Given that the assets are pooled together, investors can often invest in more securities through mutual funds than can reasonably be achieved alone.
The interest earned on fixed-income investments usually is taxable income, although some government bonds may be tax-free. Mutual fund investors are taxed on the interest distributions based on the year that payments were accrued, according to the Fidelity Investments website. For example, investors are taxed when the income was recorded for accounting purposes despite the date the payments were received. Individual investors who own bonds outside of a mutual fund are similarly taxed on the interest that is earned, but the tax is applied in the year that the investor receives distributions.
Mutual fund investors may be subject to different distribution schedules, which are when interest payments are made. According to mutual fund firm Franklin Templeton's website, the frequency for fixed-income interest payments depends on the firm. Interest distributions could be paid each month or quarter, or could be distributed once or twice each year. Individual investors in traditional fixed-income securities are likely to receive distributions every six months. Variable bonds are less traditional because the interest rate gets readjusted, and payments are made according to changing rates.
Investing in fixed-income exchange-traded funds, or ETFs, could give investors the best of both investment worlds. ETFs, which are a type of mutual fund that trades like individual securities, are a lower-cost option versus traditional mutual funds, according to a 2009 article in "Kiplinger" titled "Welcome Additions: More Bond ETFS." The benefits are efficiency and cost savings. Investors can trade fixed-income ETFs with ease, similar to the way that individual securities are traded, while avoiding the transaction costs that are associated with trading multiple individual securities or changing mutual funds.
- Fidelity Investments: Tax Implications
- "Kiplinger"; Welcome Additions: More Bond ETFs; Jeffrey R. Kosnett; April 2009
- U.S. Securities and Exchange Commission. "The Laws That Govern the Securities Industry." Accessed March 26, 2020.
- MFS Investment Management. "Firm Brochure," Page 1. Accessed March 26, 2020.
- U.S. Securities and Exchange Commission. "Distribution [and/or Service] (12b-1) Fees." Accessed March 26, 2020.
- Congressional Research Service. "Exchange-Traded Funds (ETFs): Issues for Congress," Page 1. Accessed March 26, 2020.
- U.S. Securities and Exchange Commission. "SEC Proposes to Streamline ETF Approval Process." Accessed March 26, 2020.
- ETFGI. "ETFGI reports assets invested in Smart Beta Equity ETFs and ETPs reached a record $835 billion at the end of November 2019." Accessed March 26, 2020.
- Internal Revenue Service. "Topic No. 409 Capital Gains and Losses." Accessed March 26, 2020.
- Internal Revenue Service. "Topic No. 404 Dividends." Accessed March 26, 2020.
- Internal Revenue Service. "Mutual Funds (Costs, Distributions, etc.)" Accessed March 26, 2020.
- Internal Revenue Service. "401(k) Plans." Accessed March 26, 2020.
Geri Terzo is a business writer with more than 15 years of experience on Wall Street. Throughout her career, she has contributed to the two major cable business networks in segment production and chief-booking capacities and has reported for several major trade publications including "IDD Magazine," "Infrastructure Investor" and MandateWire of the "Financial Times." She works as a journalist who has contributed to The Motley Fool and InvestorPlace. Terzo is a graduate of Campbell University, where she earned a Bachelor of Arts in mass communication.