There are several obvious advantages in investing in bonds:
• Generating income: Bonds’ coupon payments provide investors with a fixed amount of income at regular intervals.
• Preserving capital: Investing in bonds allows bondholders to protect the value of their overall investments with assets that promise to pay back the principal amount. Since bonds are usually considered less risky investment instruments than stocks, they can be a safer choice for investors who want less uncertainty in recovering losses.
• Diversification: Investing in a balance of bonds, stocks, and other asset types can help investors build a portfolio that seeks the best possible returns and withstands market fluctuations. Low-risk or risk-free bonds, such as Treasuries, provide diversification from more volatile stocks during times of economic slump and market downturns.
• Tax advantages: some bonds are useful for investors who seek to reduce their tax burdens. For instance, the income from U.S. Treasury securities is tax-free on the state and local levels. The interest on municipal bonds is tax-free on the federal level as well, and if an investor owns a municipal bond issued in the state where the investor lives, the interest on this bond is not taxable by the state either.
As with any investment, investing in bonds also involves some risks:
• Interest rate risk: Interest rate shifts are the main cause of price volatility in bond markets. Fixed-rate bonds are subject to interest rate risk. When the market interest rate rises, the market price of bonds will fall since the investors will get higher interest rates by purchasing a newly issued bond that offers a higher interest rate.
• Credit risk: Credit risk is the possibility that an issuer could default on its debt obligation. Even though credit risk does not directly affect the bond’s interest payments (unless the issuer defaults), downgrading of the bond can easily cause the bonds’ market price to drop, prompting the holders of such bonds to sell them.
• Inflation risk: Inflation is the rate at which the price of goods and services rises over time. Since bond interest payments are fixed, inflation can depreciate their value. If the inflation rate supersedes the income from the bond’s interest payment, the bond’s returns go down.
• Liquidity risk: Bonds are less liquid than stocks because investors tend to purchase bonds and hold bonds rather than trade them. While super-safe Treasuries can easily find a buyer on the market, other bond types, - especially junk bonds, can be extremely illiquid.
Most of the disadvantages associated with these risks can be mitigated by diversifying investments within the investment portfolio. Stay tuned with Wolfline Capital, and you will learn many useful and insightful things on capital markets and asset management.