Understanding the advantages and disadvantages of bond investing is important for every investor. Like any financial instrument, bonds have weaknesses and strong points, but they can still be perfectly useful in a financial portfolio.
Carefully considering the advantages and disadvantages of a potential bond purchase will help strengthen your present finances, and brighten your financial future.
Advantages of investing in bonds
Diversification is the primary advantage bonds offer. Most bonds will usually move in the opposite direction of the stock market, most of the time. If stocks dip, bonds can ease the pain.
Steady income is another virtue of bonds. Most types of bonds pay regular interest, at the time and in the amount you expect.
For investors who need to be sure that they will have a certain amount of money at a given time, bonds are one good choice. Purchased with attention to maturity dates, bonds will return a certain sum of money at a certain time. For example, if the money will be needed in five years, purchase a bond with a five year maturity, and make sure it cannot be called, bought back from you, before then.
Bond investors can choose the amount of risk they wish to tolerate. Short maturity government bonds are extremely safe, while longer maturity corporate bonds are somewhat riskier, and high-yield bonds are very risky. Of course, riskier bonds do pay higher interest.
Government bonds are easy to buy, with a non-competitive bid though the Treasury Direct program.
Some bonds allow investors to legally avoid paying taxes. Municipal bonds are free of Federal tax, for most investors, and are often free of local taxes in the area where they were issued. A tax adviser can help investors determine if tax-free bonds, which are usually lower yielding, are suitable for their situation.
Interest rate changes can sometimes work in a bond investor’s favor. If interest rates fall, other things equal, bonds will rise.
Inflation is deadly to most bonds. In inflationary times, investors will receive the income promised by their bond, but it will be worth less. To fight inflation, better investments include reliable stocks, commodities, and TIPS, Treasury Inflation-Protected Securities, which are government bonds that pay at a rate adjusted for inflation. TIPS are available through Treasury Direct.
Interest rate changes can be bad for bondholders. When interest rates rise, bonds will drop in value. They have to drop in price until their yield matches the current yield for a new bond of the same type. Longer maturity bonds will drop more, while shorter bonds will be relatively unaffected. Investors who plan to hold their bond to maturity may not care what the price is in the meanwhile.
Purchasing individual bonds can be expensive and complicated compared to stock purchases, and it can be hard to diversify. For these reasons, many investors choose to make their bond purchases through bond mutual funds or ETFs. AGG, for example, is an Exchange-Traded Fund that tracks the entire United States investment grade security market. SHY, on the other hand, tracks the performance of one to three year government bonds.
Bond returns are lower than stock returns. Over time, this lower return will result in a less valuable nest egg. For this reason, few investors will want to own nothing but bonds.
Bonds do have their place in a portfolio though. A portfolio that contains some stocks and perhaps some commodities will gain stability and diversification from a few carefully chosen bonds.