Bonds are comparatively safer than investing in stocks. Bonds have the capacity to create a balance in an investment portfolio. Suppose you have invested in stocks predominately, you can include bonds as they would diversify the assets to lower your risk on the whole. The only risk in buying bonds is the dependability of the issuer as some may not be able to make interest or principal payments on time; nevertheless, in most cases, they are definitely not risky like stocks.
Most financial advisors would agree that bonds can be a valuable addition to your investment portfolio. Though stocks draw high interest, they come with their share of risk — you can only invest in more stocks than bonds if you have the savings and resources for long-term investments, and stay robust during market fluctuations.
Understanding bonds
Initially, as a young trader, you could have 10% in bonds. As you get older, your portfolio could have at least 50% invested in bonds. Moreover, you could get potential tax breaks if you had purchased municipal bonds. Nearing retirement, you may not want to get into the stock market fray with intense trading strategies; in that case, you need bonds in your portfolio. Senior citizens can invest in bonds as they are a reliable asset; they pay interest at fixed rates and regular intervals. However, you will not get a high-interest rate. People prefer bonds for security and reliability even though it comes at a price — lower interest rates that would be almost half as other investments.
Bond interest rate
Bonds are offered for a fixed term, usually for a year to 30 years. It does not mean that you should hold on to your bond until the term ends. You can always resell your bond at the right time — you would make a profit if you sell a bond when interest rates are lesser than what it was when you bought it. If you sell at a time when interest rates are higher, you would have a loss. You could also sell a bond earlier on secondary markets ahead of its complete maturity; however, you may not make a profit or even get back the original principal.
Some investors purchase a bond fund that would pool a mixture of bonds to diversify the portfolios. Anyways, these funds would be volatile as they don’t have a set price and interest. A bond’s interest rate is set during the time of purchase and interest is paid either monthly, quarterly, semiannually, or annually until complete maturity. The full original principal is paid back at the end of the term.
Bonds are not completely free from any trouble
Purchased bonds drop in value when interest rates go up. If interest rates rise, the coupon rates of new bonds would rise as well. This makes investors purchase new bonds that lessen the resale value of existing bonds still having the old lower interest rate.
Sometimes one might have difficulty in selling the bond if interest rates go up. The bond issuer might get into a crisis and would not be in a position to pay the interest or principal on time — this is commonly known as default risk. The rise in prices or inflation could decrease the purchasing power over time; this makes the fixed income you get from the bond insignificant over the years.
Most bonds’ interest rate depends on the creditworthiness of the issuer. Generally, U.S. government bonds are regarded as the safest investment. Second comes state and local government bonds, followed by corporate bonds. However, treasuries (federal government bonds) have low interest rates because it is highly unlikely that the federal government would shut down one day. Some companies might offer an unrealistically high rate of interest on bonds; however, you should try to avoid them they might know that their company would fail before paying off the debt, and would plan to declare bankruptcy.
