Investing in bonds is considered a stable way to grow your wealth. They offer investors a fixed income stream in exchange for lending money over some time. Despite their “boring” reputation, bonds play an important role in a balanced portfolio by offering stability, diversification, and reliable income—especially for risk-averse investors or those nearing retirement. Just like any other investment, bonds come with a set of rewards and risks that are important to note before investing.
In this article, we will explore bonds, their workings, the various types, and the benefits and risks that every investor should consider before investing in bonds.
What are bonds?
Bonds, sometimes known as fixed-income investments, are debt securities issued by governments, corporations, and municipalities to raise money.
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Individuals lend money to these entities at a certain interest rate for a specified amount of time, usually 1 to 30 years. On maturity, these entities repay the individuals with interest in addition to the original amount invested.
Here are some terms that are important to understand when dealing with bonds:
- Issuer: This is the entity that issues the bond to raise money
- Face value/Par value: This is the principal amount the bond is worth when it is issued. Most bonds have a standard face value of $1000.
- Coupon: This is the annual interest rate paid by the bond, expressed as a percentage of the bond’s par value.
- Yield: This is the overall return you earn from the bond. The main types of yield include Current Yield and Yield to Maturity.
Understanding Bond Periods
There are various phases of a bond’s life from issuance to maturity.
When investing in bonds, understanding a bond’s period helps you understand when to expect receipt of returns, how long your investment will be locked up, and the timing of risks such as interest rate changes.
Here are the main bond periods:
- Issuance period: This is the period when a bond is first issued to investors. The issuer sells bonds to investors who purchase them at their face value. This period is important as it sets the bond’s terms, including the interest rate and maturity date.
- Interest Payment period: Here, you as a bondholder receive regular interest payments based on your bond’s coupon rate. These are made semi-annually or annually until the maturity of the bond.
- Maturity period: This is the final phase of a bond where the issuer repays the face value of the bond to a bondholder. This is a very crucial period in determining the duration of the interest payments and the bond’s lock-up time. It is also here that bond retirement could occur, where the issuer repurchases the bonds it had previously issued.
- Callable period: Some bonds are callable, meaning that the issuer has a right to redeem the bond before its maturity date. This could occur if interest rates drop. The bond issuer refinances the debt at a lower cost by issuing bonds at a lower rate. Call provisions are often a feature of corporate and municipal bonds. For you as an investor, calling of a bond creates reinvestment risk, meaning you have to fins a new place to put your money in, even though you have barely made any money from the previous investment. These types of bonds tend to offer higher coupon rates to compensate for this reinvestment risk.
Types of Bonds
Bonds come in various types, each with unique characteristics, different risks and benefits. Here is a breakdown of the main types of bonds you can invest in.
Government Bonds
These are debt securities issued by national governments to raise money to fund public infrastructure projects or government spending.
Government bonds are among the most stable investments when issued with financially stable countries, as they are backed by the full credit and faith of the issuing government. Even though they provide safety and stability, they offer lower returns as compared to corporate bonds or equities.
Corporate Bonds
These are fixed-income securities issued by corporations to finance company expansions, acquisitions, and other business activities. Investing in bonds is fairly straight forward, but if you are looking to take on more risk for higher returns then these are the bonds you should invest in.
They are further categorized into investment-grade and junk bonds. Investment-grade bonds are safer than junk bonds which are riskier but offer higher returns.
Zero-Coupon Bonds
Unlike most bonds, these zero-coupon bonds do not pay periodic interest rates. Instead, you only make a return when you sell them at a discount to their face value.
Profit is realized at maturity when the bond is redeemed for its full face value. It is therefore suitable for long-term investors who do not have the need for regular income payouts.
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Benefits of investing in bonds
Here are some of the benefits that come with investing in bonds:
- Bonds provide a steady income
Bond investments offer fixed, regular interest payments. When purchasing a bond, you can lock in a particular maturity date and a specific interest rate. This means that you can calculate how much payouts you’ll be getting from that bond as interest. Therefore, if you are a retiree or someone who wants to live off their investment income; regardless of market fluctuations, go ahead and invest in bonds.
- Bonds offer capital preservation
Bonds are designed to return the principal amount at the end of the maturity period. Unless the issuer defaults which rarely happens, bondholders will receive their initial investment back. This ensures that the capital is preserved, making bonds a safer investment.
- Bonds offer portfolio diversification
Portfolio diversification involves spreading your investments across various asset classes, such as stocks, bonds, and real estate. The positive performance of some assets can offset the negative performance of others, leading to more stable returns. In a volatile market, stocks will lose a significant value in a short time while bonds only lose a small portion or remain stable.
- Bonds offer tax advantages
Certain types of bonds such as municipal bonds offer tax-free interest income. The income on equities and most money market funds is taxable unless held in a tax-deferred account. For investors in higher tax brackets, these tax-exempt bonds offer great tax savings while still generating income. This further means greater yields on the bond investment.
Risks of investing in bonds
As you think about investing in bonds, it is important to note some of the risks that come with these asset classes.
- Credit Risk
Even though investing in bonds is fairly safe, the risk of default is still present, just like other riskier investments. There is a credit risk, which refers to the possibility that a bond issuer will fail to make interest payments or pay the principal amount. An investor would in such a case, lose part or all of the investment. Government Bonds are generally safer to invest in comparison to corporate bonds and bonds from less stable countries that carry a greater default risk.
- Inflation Risk
Inflation is the gradual fall in the purchasing power of money due to an increase in the price of commodities. Whilst holding a bond, inflation could increase drastically and at a faster rate than your investment income which is usually fixed. This is one on the main downsides to investing in bonds. When this happens, you achieve a negative rate of return, which reduces your real return on bond investment, particularly long-term bonds.
- Interest Rate Risk
As mentioned earlier, if you hold a bond until the maturity date, you will essentially receive the face value and the interest. What happens if the interest rate rises? Newly issued bonds will be more attractive due to the higher rate. Since older bonds have a lower rate, you may have to sell them at a discounted price
Choose your bond investment journey wisely
Investing in bonds comes with numerous benefits from capital preservation to steady income and diversification, making them a useful investment tool. However, they come with various risks including default and inflation risks.
To make the most of bond investments, it’s important to fully understand these factors and align them with your financial goals. With the right approach, bonds can provide a solid foundation for long-term financial growth and stability.
