Even if bonds traditionally give lower returns when compared
with stocks, bonds still have a great place in everyone’s portfolio. There are indeed many huge reasons to invest
some money on bonds. However, there are
also good reasons why you should be careful when investing in them.
In this article, we’re going to talk about the good and bad
things about bonds. If you’re planning
to join the bond market, this article is a must-read for you!
The Good Stuff
Bonds offer diversification.
Bonds generally have lower volatility when compared with
stocks. That means it can stabilize the value of your portfolio in times of
stock market vulnerability.
Letting yourself have a combination of both stocks and bonds
over the long term can definitely provide substantial returns with less risk
than a portfolio dedicated to only one type of investment.
Bonds can provide stability.
If you think you will need access to large sums of money in
the near future, it should be an excellent choice to avoid pouring money on a
volatile market like the stock market.
Since the larger slice of the return on bonds comes from the
interest payments, the volatility or the fluctuation in the price of the bond
will just have little impact on the value of your investment.
Bonds give consistent income.
Quite different from dividend stocks, coupon payments are
consistently sent at regular intervals. If
you are searching for consistent income, bonds might be a much better
alternative than dividend payments that not all stocks offer.
Bond payments are federal tax-free.
Payments coming from some bonds are exempted from federal
taxes. For people in the higher tax
brackets, these investments are most of the time excellent vehicle for their portfolio.
The Risky Items
Most of the time, bonds are called “fixed income” investments. But that doesn’t really guarantee fixed
income. Bonds also come with risks, even
if they are mostly considered safer investments than stocks. Bonds can still lose their value while you’re
holding them. Here are some of the most
important risks you need to be careful about.
Interest rate risks
The prices of bonds are inversely correlated to interest
rates. That means if interest rates
increase, the bond price will go down. The
interest rate on a bond is indicated at the time it’s issued. In general, the coupon will reflect interest
rates at the time of its issuance.
On the flip side, if interest rates increase, people will be
reluctant to buy the bonds in the secondary market at the earlier rate.
Credit Risk
People sometimes default on their loans and borrowed
items. Similarly, organizations that
issue bonds occasionally default on their obligations. If that’s what happens, the remaining value
of your investment can be lost.
Bonds coming from the government are in general free from
the risk of default since they can just print money if they needed more. However, the bonds that come from
corporations are more prone to the risk of default since there’s always a
chance for businesses to go out of business.
Call Risk
Some bonds can be called by the company that has issued them
in the first place. When bonds are called,
the bond holder has to redeem the bonds. The reason for such action is usually
so that the issuer can offer new bonds at another interest rate. This compels the
investor to reinvest the principal sooner than expected, usually at a lower
interest rate.
Inflation Risk
Although there are some exceptions, the interest rate on
bonds is set on the day it is issued, and the same also goes for the principal
that should be returned on maturity. If there
is a substantial move in the inflation rate over the time you’ve held the bond,
the real value of your investment can certainly suffer.
Conclusion
Bonds are good investments but as a responsible investor,
you should bear in mind all the risks you have to suffer as you invest in
them. Nonetheless, bonds should have a
place in your portfolio, along with common stocks, preferred stocks, dividend
stocks, currencies, options, futures, and others.
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