If you’ve got your eyes set on increasing your capital, investing into bonds will most likely pop up as a choice. The talk of investing is getting louder and louder… it’s pretty hard to shut it out – nor should you. The best solution to uncertainty is getting informed! In this article we are drilling deep into the pros and cons of investing in bonds.
Pros of bond investing include consistent income, lower risk, clear risk rating, higher return compared to other low-risk investments, and higher stability in terms of value fluctuation. While the cons include a low chance for high gains, requiring a larger initial investment, lack of liquidity, and direct exposure to interest rate risk and credit risk.
Every type of investing comes with certain advantages and disadvantages. By understanding what bond investing brings, you’ll be able to determine whether you can see yourself as a bond investor, or not.
So, without further ado, let’s unmask the true nature of bonds. You’ll get to know how they work, what makes them a favourable investment, and what you should be aware of. Are you ready?
What Are Bonds and How Do Bonds Work?
Before we start to judge bond investing, we need to clarify what they are and how this type of investment functions.
Bonds are issued by companies and governments as certificates of the bondholder’s loan. To put it plain and simple—you give money to a company or the government for a set period of time and they give you the bond as proof. Because you are so generous to give away your money, the bond issuer will pay you a fixed rate of interest. The interest is usually paid annually or semi-annually.
Because of the fixed interest paid over a given period, bonds fall under the fixed income investment category. If you’re wondering why they’re called ‘fixed income investments’ then I’d recommend checking out my post ‘Bonds: Why Are They Called Fixed Income‘ as I go through everything on there!
Based on the issuer, the types of bonds are:
- Government bonds or gilts – Issued by the British government;
- Other government bonds – Issued by governments from other countries;
- Corporate bonds – Issued by companies; and
- Savings bonds – Issued by banks and building societies.
For the sake of confusion-free talk about bonds, here are a few key terms that you should know:
- Coupon – The interest rate;
- Principal – The face value or par value;
- The issue date–The date when investors can buy the bond;
- The offer period – The period for which you’ll lock in the bond;
- The maturity or redemption date – The date when you will get your investment capital back; and
- Yield – The return you get on a bond.
Bonds are rated according to their creditworthiness from C (the lowest) to AAA (the highest grade). BB and lower rated bonds are called junk bonds. So, a financially strong company that is likely to repay the debt without an issue will be rated AAA.
The reason why some people invest in junk bonds is the high yield. If the company rises from the ashes, the bond’s price will significantly rise. Also, the bond issuers compensate for the high risk with higher interest. Does investing in junk bonds sound like gambling to you? If it does, you might want to read my post ‘Is Investing Gambling-The Truth.’
The Pros and Cons of Bond Investments
Let’s take a quick overview of the pros and cons and then, we’ll get to dig a little deeper into each one of them.
| Pros | Cons |
| – Consistent income; – Low-risk investment; – Clear rating; – More stable in terms of value fluctuation; and – Higher return compared to other low-risk investments. | – Low chance for higher potential gains due to fixed returns; – A larger amount needed for making an investment; – Lack of liquidity; – Interest rate risk; and – Credit risk. |
Pros
Consistent income
If you want your investment to regularly add pounds to your money pile, bonds can do that for you. Typically twice a year you’ll get a pay-out in the form of interest.
Bonds are more predictable as you have a fixed interest rate and a fixed principle that you get back on the maturity date. You know precisely how much you’ll gain from this investment.
So, if you have a long-term goal—such as saving for retirement—you can ensure that you grow yourself a nice amount of funds for a decent retiree life. If you are already retired and you are considering investing, my post ‘Investing for the Retired: Everything You Need to Know‘ can be just what you’ve been looking for.
Low-risk investment
Gilts or government issued bonds are one of the safest forms of investing. There is truly a low chance that the Queen will casually “forget” to pay you your interest. If you like hard proof, just count on the fact that the UK bonds have an AA rating. So, anyone who wants to dip a toe in investing but isn’t a fan of risk, this is where your search can end.
While corporate bonds are considered riskier than gilts, they are still in the low-risk section of investment types. If you put your money on AAA rating bonds and do your research, you have very little to fear.
There’s also the fact that in case of liquidation, bondholders have priority over shareholders. Meaning, investors who own a company’s bonds get paid first.
Clear rating
The bond rating makes investing easier as you have a clear view of companies’ creditworthiness. Credit rating agencies such as Standard & Poor’s analyse the issuers and set the rating. You can use this rating to filter your search for the bonds you are after—whether that’s low-risk bonds with AAA rating or junk bonds that might turn into a jackpot.
However, it is highly advisable that you still do your own research. As Peter Lynch, wrote, “Investing is fun and exciting, but dangerous if you don’t do any work.” I’d recommend reading his book ‘One Up On Wall Street – it’s in my recommended books list.
More stable in terms of value fluctuation
Bonds aren’t always plain sailing though. The value can fluctuate because of inflation rates and interests. No investment is completely risk-free. However, compared to other investments like stocks, bonds are less volatile.
Why is that, you ask? As mentioned, bonds are predictable. They have a known income trajectory and their prices are less likely to change. So, if you want to avoid high chances of value fluctuation, you can achieve that with bond investments.
Higher return compared to other low-risk investments
If you are determined to stick to the safe side of investing, bonds may be your best pick among low-risk investments. The bond’s interest rates are usually higher than what you’ll get for depositing your money in a savings account or certificate of deposit (CD).
With bonds, you can keep your money safe and get a better return than you would from keeping your money in a bank. So, bonds are ideal for anyone who wants to move past the savings-account-kind-of-life, but without the risk that can come with other forms of investing.
Cons
Low chance for higher potential gains due to fixed returns
The low risk/low return ratio now steps into the picture. With the fixed income that you get and the safety that comes with AAA bonds, you give up on higher potential gains.
For example, if you invest in property, you can buy a house, fix it up, wait for the property prices in that neighbourhood to rise, and sell it for a high gain. With bonds, you get your set interest and the amount you invested when the bond matures.
You can, however, trade bonds on the secondary market after they are issued. But, because of the less volatile bond prices, there is a lower chance that you’ll make a high profit. Experienced investors may be able to achieve that if they spot a junk bond with good potential. Buying such bonds and trading them later can lead to greater returns.
A larger amount needed for making an investment
Gilts don’t cost much, but corporate bonds are a different story. Corporate bonds can be more demanding in terms of the initial investment due to higher minimum investment amounts.
You can go fishing for bonds with low investment sums, but that does limit your choice. The minimum amounts don’t need to be a setback, but for someone with low capital, it can present a challenge.
Lack of liquidity
Compared to stocks, bonds are less liquid. If you own bonds issued by a startup or smaller company, it will be harder for you to find a buyer. With a smaller pool of potential buyers, bonds liquidity goes down.
Government bonds, on the other hand, are highly liquid. Investors see them as an extremely safe investment that boosts your performance outcomes.
Interest rate risk
If you plan to patiently wait for the maturity date and collect the fixed interest, the interest rate won’t affect you. However, in case you are considering trading, you should know that bonds are directly exposed to interest rate risk.
The value of bonds is affected by the growth or decline of interest rates. When interest rates go up, the price of bonds goes down—and vice versa.
The way this works in the real world is that new bonds carry higher interest rates and lower the demand for older bonds. If you hold your bond for years, but you need to sell it before maturity, the price of the bond will be depressed and you’ll receive less money than you invested in the bond. Since the market price of older bonds lowers to offset new bonds with attractive rates, the interest rate risk is heavily linked to market risk.
Credit risk
Another risk you should be aware of is the credit risk. While you do have a credit rating and your own research as a foundation for smart bond investing, there are no guarantees that the company will pay you back. The issuer does promise to pay you the interest and the principal, but if the company goes under, that can lead to irreparable damage.
If you invest in bonds issued by reliable companies, this risk will be lower. The credit rating is calculated based on the company’s ability to pay up the loan. But what if that loan changes? What if the company’s liquidity decreases? The unpredictability of the business world acts as a constant reminder that the risk always exists.
Yet again, credit risk is more present with corporate bonds as gilts are deemed to be liberated of risk.
What Will Prevail—The Good or The Bad?
Now that you know the ins and outs of bond investments, you can think about it more soundly. However, before you take the leap, you know that investing is a big step that should be taken with care.
What this means is that you need to thoroughly think about your options, risk tolerance, abilities, and needs before taking your pick. The bonds can be exactly what you need if you want a safe investment for your long-term goal. It can help newbie investors to walk into the investors’ community without fear.
Bonds are also a solid solution for diversifying your portfolio. If you have volatile investments, bonds can balance them out. Even if equities fail you, you’ll have bonds to keep you afloat. You can learn more about diversification and makes it so important in the post ‘Only Invested In One Stock? Here’s Why That’s A Bad Idea.’
If you feel more daring, you can look into bond trading and how to make it work. In this case, you should educate yourself more about assessing companies’ debt, liquidity, business plan, and cash flow. All of this can help you surface bonds with potential.
Overall, bonds are a wide notion and they come with a variety of possibilities. From riskier investments to almost risk-free investment options, bonds have it all. If you have any doubts, questions, or uncertainties about this type of investing, connect with a financing advisor. A professional can understand your wants and find the perfect match for you.
Pros and Cons of Bond Investing—You Can’t Have One Without the Other
Having a list of advantages and disadvantages helps you see the bigger picture of bond investing. However, it won’t be able to determine whether an investment is good or bad. Every person looks at these characteristics from their unique standpoint so opinions will differ.
Let me just leave you with a small reminder—every investment comes with a risk. So, don’t let the risks intimidate you. Typically, the higher the risk, the higher the reward so do your research and invest where you feel comfortable to do so.