Benefits and Risks Associated with Bonds
While bonds traditionally earn lower returns than stocks, that does not mean there isn't a place in your portfolio for bonds. The most common reason for investors to purchase bonds are below:
- Diversification - Bonds tend to be less volatile than stocks and can therefore stabilize the value of your portfolio during times when the stock market struggles. Having a combination of both types of investments over the long term can often provide comparable returns with less risk than a portfolio devoted to only one type of investment.
- Stability - If investors know they will need access to large sums of money in the near future-for example, to pay for college, a home, etc.-then it does not make sense to place that money in a highly volatile investment like stocks. Because the majority of the return on bonds comes from the interest payments (the coupon payments), fluctuations in the price of a bond will have little impact on the value of the investment.
- Consistent Income - Unlike stock dividends, coupon payments are consistently distributed at regular intervals. Individuals seeking this consistent income might find bonds a better alternative than the dividend payments some stocks offer.
- Taxes - Payments from some bonds are exempt from federal taxes . For individuals in high tax brackets, these investments are often an excellent vehicle for their portfolio.
Bonds are often called "fixed income" investments, but don't let that term fool you. Bonds are not riskless investments. While they are usually considered much safer than stocks, bonds can still lose value while you hold them. Here is a brief look at some of the risks associated with bonds:
- Interest rate risk - Bond prices are inversely related to interest rates, so if interest rates increase, the price of the bond will decrease. The interest rate on a bond is set at the time it is issued. Generally, the coupon will reflect interest rates at the time of issuance. However, if interest rates increase, people will be unwilling to purchase the bonds in the secondary market at the earlier rate. For example, if the coupon is set at 6% and interest rates in the market are at 7%, the interest rate on the bond is well below what you could get from a different investment. Therefore, the price of the bond will decrease so that the capital appreciation will make up for the difference in interest rates. (For this reason, it can be risky to buy long-term bonds during periods of low interest rates.)
- Credit Risk - Just as individuals occasionally default on their loans or mortgages, some organizations that issue bonds occasionally default on their obligations. If this is the case, the remaining value of your investment can be lost. Bonds issued by the federal government , for the most part, are immune from default (if the government needed money it could just print more). Bonds issued by corporations are more likely to be defaulted on - companies often go bankrupt. Municipalities occasionally default as well, although it is much less common. The good news is that you are compensated for taking on the higher risks associated with corporate bonds and municipal bonds. The yield on corporate bonds is higher than that of municipal bonds, which is higher than that of treasury bonds. Moreover, there is a rating system that enables you to know the amount of risk each class of bond entails.
- Call Risk - Some bonds can be called by the company that issued them. That means the bonds have to be redeemed by the bond holder, usually so that the issuer can issue new bonds at a lower interest rate. This forces you to reinvest the principal sooner than expected, usually at a lower interest rate. This subject will be further discussed in later sections.
- Inflation Risk - With few exceptions, the interest rate on your bond is set when it is issued, as is the principal that will be returned at maturity. If there is significant inflation over the time you held the bond, the real value (what you can purchase with the income) of your investment will suffer.