An Introduction to Investing in Bonds
Unlike stocks which are a form of ownership in a company or organization, bonds are a form of debt. Bonds are contractual loans that are made between the investor and the institution as a loan or financial agreement. The rate of return or premium that is paid to the investor is referred to as a coupon. Investors can earn money in the form of interest payments and from the capital appreciation of the bond if it is sold on the open market. Like any other investment type, bonds are not appropriate for every investor. Understanding the advantages and disadvantages is important to selecting whether bonds are the right investment choice for an individual investor's portfolio.
Bonds offer investors several advantages including a conservative and more secure rate of return, relatively predictable returns and higher rates of return in some cases than banks.
Security- In most cases, investing in debt instruments is safer than investing into equity investments. The primary reason for this is that the debt holders have priority repayment over equity shareholders in the event of a company bankruptcy. Considered to be the safest bond investments are those backed by the full faith of the federal government. Even though bonds are considered to be safer investments, they are not completely free of risk and should be evaluated as a portion an investor's portfolio.
Income- Most bonds will pay a dividend income to investor's during certain times in the investment cycle. Bond income will vary based upon the bond type and the level of risk associated with the bond issuer. Bonds that carry more Issuer risk pay higher interest rates to investor's than more secure Issuer's.
Inverse Relationship to Equities- Bond returns are typically inverse to equity returns, giving investors a form of diversification within their portfolio. By having both investment types within a portfolio based upon the appropriate asset allocation for the investor, there is some potential portfolio protection added.
Inflation Risk-As bonds are a fixed investment, they may not offer protection against inflation changes within an economy. If the interest rates on a bond investment are low and inflation increases more than average or expected, the investor has the potential to lose purchasing power within their portfolio.
Interest Rate Risk- The prices of bonds are affected by fluctuations in interest rates within the economy. Bond prices move inversely to interest rates; when interest rates rise, bond rates fall and vice versa.
Callable Bonds- Some bonds are callable, meaning that the Issuer can redeem the bonds issued. This is common when interest rates decline, making it more favorable for the Issuer to refinance their debts. If this occurs, the investor would be forced to redeem their bond and replace it with a new one that potentially would have lower coupon rates. For an investor who is relying on this income for their lifestyle, this can be a substantial disadvantage.
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