Updated on Mar 02 2018
Bonds contribute an element of stability to almost any portfolio and offer a safe and conservative investment. Bonds are quite popular, but don’t always offer a big return. Whether or not you invest in bonds depends on your unique financial situation.
What is a bond?
A bond is form of debt investment in which you loan money to a corporate company, city or government for a specific period of time at a variable or fixed interest rate. Bonds are ‘IOUs,’ but you serve as the bank. Traditionally, bonds are considered the safer, more conservative, investments as the risk of loss of principal is pretty small. Bonds provide consistent income as they have periodic coupon payments. On the downside, the rate of return on bonds is often lower than that of other investments.
What are the advantages of bonds?
Investing in debt is safer than investing in equity as debtholders have priority over shareholders. For this reason, bonds are a much safer investment than stocks as there is a measure of legal protection. In a worst-case scenario, such as bankruptcy, the creditors or ‘debtholders,’ usually get at least some of their money back, while shareholders often lose their entire investment.
Also, Treasury bonds from the U.S. government are considered “risk-free” as they’re backed by the government and corporate bond coupons are considered more stable than company dividend payments because companies are legally bound to pay interest on bonds before considering payment of any preferred common stock or dividend.
Bonds suffer less day-to-day volatility than stocks, and the interest payment of bonds are often higher than the general level of dividend payments. Bonds also come with indentures, or a formal debt agreement that establishes the terms of the bond issue, and covenants, the clauses of the agreement, specifying the rights of the bondholders and the duties of the issuers; which makes the investment clear and more stable than other investments.
What are the disadvantages of bonds?
While bonds are relatively conservative, they still carry some risk.
Bonds are subject to the following risks:
- Interest rate risk – The risk that rises for bond owners from fluctuating interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market. The sensitivity depends on these two things:
- The bond’s time to maturity
- The coupon rate of the bond
- Prepayment risk – The risk associated with the early, unscheduled return of principal on a fixed-income security.
- Credit risk – The risk on a debt that may arise from a corporate issuer defaulting on debt obligations.
- Reinvestment risk – The possibility that the investor might be forced to find a new place for his/her money.
- Liquidity risk – The risk that a company or bank may be unable to meet short-term financial demands.
A financial advisor can help you weigh the pros and cons of a particular bond with your unique investment profile to help you determine whether it’s a good investment.
What types of bonds should I avoid?
Not all bonds are created equal. In constructing a safe portfolio, an investor should focus on investment-grade rated bonds. These are bonds that carry a minimum credit rating of BBB or higher. Bonds that would fall into this category include the following:
- U.S. Treasury securities
- U.S. government agency securities
- Most mortgage-backed securities (MBSs)
- Investment grade-rated municipal securities
- Investment grade-rated corporate bonds
Bonds that are considered less safe include high yield junk bonds, emerging market bonds and some securitized products. This means you need to be careful in selecting your bond to match your investment goal and individual situation. Also, bonds are yielding less return than they have in the past. For example, historically, 10-year Treasury bonds have yielded an average of 6.1 percent. That yield made them a perfect complement for stocks in a retirement savings plan, as they gave a portfolio some measure of stability while still producing a solid return. Today, 10-year Treasury bonds yield less than 3 percent, which means they are not as reliable an investment.
What questions should I consider when thinking about investing in bonds?
Keep these questions in mind when thinking to lower your chance of risk when investing in bonds:
- What are my risk profile and target return?
- What are the bonds’ maturity dates and do the terms meet my investment horizon?
- What are the risks?
- Can the issuer purchase the bonds back before maturity?
- Are the interest payments made at a fixed or floating rate?
- How are the bonds secured?
An expert financial advisor can help you answer these questions and help you determine whether a particular bond might be a good investment for you.