Bonds 101: Benefits and Risks You Should Know

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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.

bonds written in cubes


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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