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.
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