Advantages and Disadvantages of Bonds
Investment in Bonds is usually considered less risky than Stocks and are more reliable for old investors who want to rely on steady interest income. Some bonds can be riskier than others but can yield more interest income in a short period. It becomes significantly important to understand the Advantages and Disadvantages of Bonds before investing. But first, it’s also important to get to know, "What are bonds?"
What are Bonds?
Bonds are an instrument of indebtedness of the bond issuer (Companies or Business Organizations) to the holders. Companies and governments use bonds to raise money by borrowing from investors. Bonds act as debt security under which the issuing companies owe the holders a debt and are obligated to pay them interest (the coupon).
Also, the issuer might have to repay the principal later on, which is also termed bond maturity. The companies are bound to pay the interest at fixed intervals to the holder. The interest can be paid semi-annually, annually, or even monthly. Bonds commercially known as Fixed Income Investments pay a fixed interest rate over a given period and then return the investor’s principal.
It’s mostly the big players like banks, insurance companies, or sovereign wealth funds that buy and trade. Most individuals willing to buy bonds need to do it through bond funds.
Components of Bonds are:
- Principal – It’s the bondholder's purchasing value, which is repaid to the bondholder when the bond matures.
- Maturity – It’s the period when a bond matures, or when the terms end as per the agreement. It can range from one day to 30 years.
- Coupon – The coupon is the interest rate paid to the bondholder at specific intervals. Usually, it’s paid semi-annually or annually.
Why do people buy bonds?
- Bonds provide a predictable income stream through interest which is generally paid twice a year.
- If a bondholder is able to hold it to maturity period, they get back the entire principal.
Why do companies issue Bonds?
Central banks, hedge funds, or Insurance companies issue bonds to get money for several reasons such as:
- Providing operating cash flow
- Financing debt
- Funding capital investments in schools, highways, hospitals, and other projects
What are the different bonds?
There are three main types of bonds:
- Corporate bonds
- Municipal bonds
What are the advantages of Bonds?
The major advantages of bonds include fixed returns and regular interests. Some of the common benefits of purchasing bonds are listed below.
1. Fixed Returns on Investment
Fixed investment in Bonds yields regular interests at timely intervals. Also, once a bond matures, you receive the principal amount invested earlier. The best advantage of investing in Bonds is that the investors know exactly how much the returns will be.
2. Less Risky
Although Bonds and stocks are both securities, the clear differences between the two are that the former matures in a specific period, while the latter typically remain outstanding indefinitely. Also, the bondholders are paid first over stockholders in case of liquidity.
3. Less volatile
Investing in bonds is safer than the stock market, which also has several other risks. Although a bond’s value can fluctuate according to current interest rates or inflation rates, these are generally more stable compared when compared to stocks.
4. Clear Ratings
Unlike stocks, bonds are universally rated by credit rating agencies. This gives further assures investors about the right time for investing in bonds. Based on the clear ratings, you can choose to buy bonds of any issuer with a better face value of bonds. However, it’s still recommended to conduct your own research before investing.
5. Investor Protection is one of the major advantages of Bonds
Bondholders are also secured against many failures. Legal protection is something investors can benefit from investing in Bonds. If a company goes bankrupt, its bondholders will often receive some money back in the form of a recovery amount.
What are the Disadvantages of Bonds?
Since it’s the money involved, there are certain Disadvantages of investing in bonds the investors or issuers may face at times. Bankruptcy is among the commonly talked disadvantages of Bonds.
1. Larger Investment needed
The cost of purchasing bonds is always among the disadvantages of Bonds. The cost is directly proportional to a company’s reputation. Even though some bonds can be purchased for relatively low sums ($1,000) , you may need a larger investment to buy some bonds. This means access to some bonds will be impossible for investors.
Bondholders may lose much or all their investment in case a company goes bankrupt. In the economy such as the USA, bondholders are given much leverage and protection laws in case of bankruptcy. This means investors are expected to receive some or all of the invested money. But in many countries, there are no protection for investors.
3. Less liquid compared to stocks
Most major corporations may have high liquidity, but bonds issued by a smaller or less financially stable company may be less liquid as fewer investors are willing to buy them. Bonds with a very high face value will also be less liquid, but the companies with low face value won’t find any investors easily.
4. Risks Involved are concerning Disadvantages of Bonds
Fixed-rate bonds are subject to interest rate risk, which means that their market prices will decrease in value when the generally prevailing interest rates rise. There are many other risks involved with Bonds, namely, Credit risk, Inflation risk, Liquidity risk, and Call risk.
- Credit risk: When the issuer fails to timely make interest or principal payments and defaults on its bonds.
- Inflation risk: Rise in purchasing power due to inflation puts a risk for investors receiving a fixed interest rate.
- Liquidity risk: Investors may not find the market for the bond; this eventually prevents them from buying or selling the bonds.
- Call risk: Retiring a bond before it reaches the maturity date is something an issuer might do in case if interest rates dip. This could be one of the biggest Disadvantages of Bonds.
Bonds are an effective option for those who need a steady and dependable source of income. Investing in bonds is what elderly investors do after retirement majorly. Selecting bonds carefully, purchasing them at the right time, and knowing the Advantages and Disadvantages of Bonds can be a big help for prospective investors.