For many years, investors have known stock markets to be the safe havens for hard earned money. Few knew about the bond markets. However, today bonds have become a popular and significant vehicle. This has led investors speculate if now is the time to buy bonds, especially in the low interest environment we find ourselves in.
Numerous successful bond investors are living proof that yes, this is a viable venture. This article will discuss bonds, how to invest in them, their benefits, and more.
Background of Bonds and the Bond Market
Bonds are instruments of fixed income variety. They are a form of a debt issued by an investor (a company or government) that needs to raise some cash to a borrower. When a company issues a bond, it asks the buyer for a loan such that when you buy a bond, you’re lending money to the bond issuer.
The issuer will then pay back the loan by a specific date and additional interest at regular intervals, typically yearly or semi-annually. Unlike stocks traded on exchanges, bonds’ trading occurs over the counter, meaning you have to buy them through a broker. The bond market is where investors trade (buy and sell) bonds. It provides investors with a stable source of regular income.
Three main groups participate in the bond market, and these are; – issuers, underwriters, and participants. Issuers are investors like corporations or various governmental levels that develop, record, and sell bonds while underwriters are risk evaluators in the financial world.
The underwriters are the ones who buy bonds and resell them for profit. Participants are entities that purchase and sell bonds and other relevant securities. When they buy bonds, they issue loans for the specified period and get interest in return.
These characteristics are outlined in a document called indenture and are vital for you to understand before investing. Here are the six essential bond characteristics to consider:
- Secured/unsecured bonds. A secured bond is backed by collateral on loan, while unsecured one has no such security.
- Coupon. This is the interest paid to bondholders, either semi-annually or annually.
- Tax status. It indicates whether the bond is taxable or not. Most corporate bonds are taxable, while some municipal or governmental bonds are tax-free.
- Face value. It’s the total amount of money the bond will be worth when it matures. It’s also the amount bond issuers refer to when calculating interest payments.
- Maturity date. The date when the bond’s principal amount is paid to the investor, and a person’s bond obligation ends. As a determinant of the bond’s lifetime, maturity is a significant consideration that you can use to push for investment goals. It can be short-term (one to three years), medium-term (over ten years), or long-term (over longer periods).
- Callability. The act of paying off some bonds before maturity. Callable bonds offer better coupon rates, making them appealing to many investors.
- The issue prices. The price at which the bond is sold initially.
Why Should You Buy Bonds?
People buy bonds for significant reasons. First, some use them to form a steady income stream. A bond’s interest payments are guaranteed, thus enabling investors to know when and how much they’ll get. It also makes bonds significant for funding particular future liabilities like college education; you can also time a bond’s principal repayment to concur with such expenses.
Next, bonds can also help you minimize your portfolio’s risk. They’re a bit correlated to stocks such that their value usually increases when stocks decrease and vice versa.Thus, you can use high-quality bonds to diversify your portfolio and reduce the overall risks of investing in stocks only. Bonds are a sure bet than stocks as they’re less volatile.
Lastly, bonds are a protection to a portfolio in times of economic downturn. Inflation falls when an economy slows, increasing future bond payments’ purchasing power. Such a slowing economy also lowers stock returns; thus, most investors turn attention to bonds, leading to price increases. Since bonds have lower volatility and higher interest payments than other securities, they’re generally considered safer investments than stocks.
Risks Associated with Bond Investment
Though considered safe, there are serious pitfalls associated with investing in the bond market. Below are some of the most common drawbacks of bonds:
- Interest rate risk. This occurs when rates change significantly from what was expected. The interest rates correlate with bonds; when they rise, bonds fall and vice versa. Declining rates leads to possible prepayment, while rising rates makes the investor stuck with something below the market standards.
- Prepayment risk. It’s the risk that a particular bond issue will get paid off before the maturity date. That’s a big blow to investors as they’ll be forced to reinvest those funds in lower interest rate avenues.
- Default risk. This is the worry that the principal amount and interests applicable won’t be paid as needed. If that happens, the investor loses part or all the initial investment and the expected interests.
- Inflation risk. This occurs when the economy’s price rates increase, making the returns associated with bonds, especially fixed bonds (those with a set interest rate from inception), to decrease.
Is Bond Market A Good Investment?
Having considered the above facts about bonds, what can we say about bond market investment? Is investing in bonds worthwhile? Of course, yes. If you’re someone interested in having some balance in the portfolio, then venturing into bonds is an ideal choice. It’s one of the smart decisions you might make in a lifetime.
What if you’re now planning to sell all your stocks and replace them with bonds? That won’t be a wise course of action, especially if you’re new to the game. Try to avoid going to the extreme ends of your desires and endeavors and act wisely. Use available resources to understand more about bond investment and related information that can help you as per your region.
The Bottom Line
Bonds are an integral investment instrument that tends to offer a reliable cash flow making them a good investment option for income investors. You can establish a well-diversified bond portfolio that can offer predictable and appealing returns, with less volatility and better yield than other money-market funds.
Even low-interest rates can’t discourage serious investors who can use options like high-yield debt or emerging market bonds to meet their income needs. Though risky, bonds are a good investment! Do what it takes to get started, check instant loan for more saving and investment tips.