A bond is issued by governments, municipalities, and corporations to raise money and is essentially a loan from the buyer to the issuer of the bond. An investor who buys a bond is lending the issuer money for a period of time in exchange for interest paid periodically and then a repayment of the principal at the bond’s maturity. Unlike investing in equities like stocks, bonds do not represent an ownership stake in a company. They represent debt.
For example, if a corporation wants to raise $10 million to construct a new facility, it may sell 10,000 bonds to investors at $1,000 each (the face value) with a maturity of five years. Based on the current interest rate environment, the company may offer an annual coupon of 4 percent, so the company will pay the investor $40 per year (the coupon payment) and then will repay the $1,000 once the bond matures in five years.
While not generally thought of as being as exciting or lucrative as investing in equity markets, bonds play a critical role for investors in terms of diversification and as a comparatively less risky investment to many equities.
Advantages of Bonds
Like any investment, bonds carry risk, but they are generally a less risky investment than equities. As mentioned above, bonds are loans that must be paid back, and they generally have priority over shareholders for repayment if a company runs into financial difficulty or goes bankrupt. Bonds also offer a good option for risk-averse investors who are uncomfortable with the volatility sometimes present when investing in stocks.
With this less risk comes a lower potential for return. For example, bonds, notes and Treasury bills issued by the U.S. Department of Treasury are considered risk-free, because they are backed by the “full faith and credit” of the U.S. government. That being the case, rates for these bonds tend to be comparatively low. As with any investment, the more risk an individual takes, the higher the return they will expect from that investment. This is also true with bonds. Highly rated bonds tend to be safer investments and will offer a lower return than lower quality high-yield bonds.
Many investors use bonds as a way to diversify their portfolio and “smooth” out the volatility associated with investing in stocks. Depending on an investor’s risk tolerance, risk capacity, and time horizon, their portfolio would likely contain a certain percentage of fixed-income investments. A more conservative investor might prefer to keep 30 percent of their portfolio in stocks and 70 percent in bonds, a balanced investor may prefer a 50-50 mix of stocks to bonds and a moderate investor might prefer an allocation closer to a 65-35 mix of stocks to bonds.
For those who want to be able to rely on a steady stream of cashflow from their investments, bonds offer an opportunity for these investors to better predict the income they will receive. This can be important to retirees or investors who do not have a significant amount of time to recoup potential losses if stock prices decline significantly in the short term.
Disadvantages of Bonds
There are certain types of risks associated with bonds. Interest rate risk relates to the risk associated with changes in interest rates. Bonds tend to have an inverse relationship to interest rates, so in a rising interest rate environment, the price of bonds tends to drop and vice-versa. Bonds generally pay a fixed interest rate that will become more attractive when rates fall and less attractive when rates rise. Zero-coupon bonds, which do not pay interest but instead trade at a discount to par value, have the same inverse relationship with interest rates. Investors can manage interest rate risk with products like forwards, futures, swaps, and options contracts.
Call risk relates to when an issuer of a callable bond redeems the bond prior to its maturity. This occurs when interest rates drop below the coupon rate of the bond. The issuer will want to refinance that debt at a lower interest rate.
Callable bonds generally pay a higher coupon rate than non-callable bonds, but if the bond is called, the investor might end up losing potential income if he or she reinvests at a lower interest rate. This reinvestment risk is the possibility cash flows from one investment will have to be reinvested at a lower rate of return.
Bonds also have an element of credit risk, because the government or company issuing the bonds could potentially default on what is essentially a loan from the investor. Investors in bonds can limit their exposure to credit risk by investing in companies or government entities that are highly rated by reputable rating agencies.
Bonds have historically underperformed stocks in the long-term, so investors can lose out on the potential gains of investing in the stock market. This is another example of why proper asset allocation is critical when investing. For most investors, a mix of both equities and fixed income investments will provide the needed balance to help the investor meet their goals.
Authored by Dennis Culver, Insight Wealth Strategies
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Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.