The Pros and Cons of Investing in Bonds
A bond is one of the most common types of financial instruments, a part of the broader asset class known as fixed income.
It is essentially a loan that takes the form of a publicly tradeable security, typically issued by a government or a company.
The bond issuer borrows money from the bond holder and is obliged to pay a pre-agreed fixed or variable rate of interest, known as the bond coupon, and to repay the amount borrowed at the bond’s maturity, a pre-determined date in the future.
A wide range of risk profiles and corresponding returns
Bond risk profiles can vary significantly, ranging from the safest U.S. Treasury Inflation Protected Securities (TIPS) which are essentially risk-free, to the lowest-grade, highest-risk type known as junk bonds.
The varying degrees of risk among different bond issues are reflected upon the corresponding difference between the interest rates they pay; the higher the perceived risk, the higher the coupon.
Expressed differently, the interest rate a bond issue carries can be broken down to the following three components:
- the market risk-free rate, derived from the prevailing yield of U.S. TIPS
- the expected rate of inflation, calculated as the different between the yields of TIPS and a nominal U.S. Treasury bond
- the credit risk premium, which essentially reflects the odds assigned by the market that the bond will not be repaid.
Advantages of Investing in Bonds
The biggest appeal of investing in bonds is the securities’ relatively safe investment characteristics. While the return an investor would typically enjoy from this asset class is not high, particularly for the safest U.S. TIPS, bonds generally form an attractive proposition when the primary consideration is capital preservation.
The relative security of bonds can be seen even further down the safety ladder. Corporate bonds offer their holders substantially more protection compared to the same issuer’s equity holders; if the issuer goes bankrupt, the former group’s claims have priority over those of the latter.
At the same time, the interest rates bondholders enjoy on a nominal bond, are typically higher than those paid on their deposits in a bank. Therefore, when investors’ funds aren’t required to be immediately accessible, as they are when they sit on a savings account, allocating money to bonds will typically form a better investment proposition.
Another attractive characteristic for investors in bonds is the predictable nature of their returns. This is particularly important for older investors, who often have to rely on a steady stream of income after their retirement, and it’s the reason why bonds are traditionally associated with the investing portfolios of people who are at this stage in life.
Disadvantages and Risks
Risk and reward should always be related in financial markets, and bond investing is certainly no exception to the rule. The flipside of the assets’ relatively safe characteristics is that their returns are also typically modest, and the market itself not appealing to thrill-seeking investors. Having said that, investing in bonds is certainly not a risk-free activity.
Provided that the bond issuer doesn’t default and the bond is repaid in full, fluctuations in bond prices will not affect those holders who intend to keep their securities until their maturity. For everyone else, however, like those investors who are active in trading bonds in the secondary market, risks do exist and can be quite substantial.
Most of the risk involved in investing in bonds is arguably associated with the credit risk component of a bond issue. While the risk-free rate and the expected rate of inflation should normally move only marginally, credit risk premiums can jump abruptly and considerably, causing significant losses to the bond issue’s holders.
Furthermore, this can be due to a number of reasons, from adverse news about the issuer to a downturn affecting the broader sector in which it operates, or even the economy itself.
Timing, therefore, and an accurate assessment of the risk-reward features of an issue, are the most important considerations when it comes to investing in bonds. In addition, patience and a willingness to play the long game are required, as it often takes months, if not years, for a bond investment strategy to turn successful.