Investing in bonds pros and cons

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AAA bonds are perceived to have little risk of default and its issuers have a very strong capacity to meet is financial obligations. Junks bonds BB and lower , on the other hand, have higher default risks and offer much higher yields as investors expect a higher return for the increased risk. Bond prices have an inverse relationship with interest rates — prices fall as interest rates increase as investors have more opportunities to generate higher yields elsewhere.

The Pros Investment returns are fixed. You receive a fixed rate of interest and your principal returned when the bond matures. You know exactly how much your returns will be. Less risky compared to stocks. Besides receiving specified investment returns, bondholders are paid first over shareholders in the event of liquidation. Less volatile. Bonds have clear ratings. This gives investors more assurance when picking a bond but you probably still want to conduct your own research and due diligence before investing.

The Cons Investment returns are fixed. While this offers higher safety for investors, it is also a disadvantage as you forgo the higher potential gains if you invested in equity. Larger sum of investment needed. While this may not be an exciting return, the ability to bank on a guaranteed return is extremely valuable for many investors, especially those approaching retirement who need to use their investment dollars as part of a fixed-income annuity.

To this effect, bonds are arguably the safest investment option available—if you do not count FDIC-insured savings accounts with their minuscule interest rates as actual investments. Bonds are a form of debt, meaning that the bond issuer has a legal obligation to repay bondholders to use their money. Therefore, if a municipality or corporation goes bankrupt, bondholders take priority during the liquidation process, as debtholders are the first to be paid after administrative and legal costs are taken care of.

Stockholders, on the other hand, are usually out of luck when bankruptcy occurs. As they are shareholders in an ownership stake of the company, they only get what money is left over after all debt has been repaid. While some municipal bonds do not have excellent yields the year government bond yield was 1. This gives investors a clear understanding of exactly how much risk they will be taking on when purchasing a bond, with riskier bonds offering more attractive coupon rates. Rating agencies use a letter-based system to judge the quality and creditworthiness of a bond.

These bonds will typically have the lowest coupon rates. Lower quality bonds and junk bonds will have lower ratings but higher interest rates to compensate for the increased risk. The Cons of Investing in Bonds Although bonds offer a steady, reliable return on investment dollars with minimal risk, investors should be aware of a few downsides. Bonds Yield Lower Returns Than Stocks While the fixed return is attractive for investors who cannot stomach the volatility of other instruments, the total return of bond investments can leave a person feeling a little hollow at the time of its maturity.

Larger Investment Sum Needed for Bonds Many bonds are used to fund large-scale public or corporate projects that cost millions of dollars. As a result, even the smallest bonds issued for such projects may run into five or six figures. Bond Defaults Can Occur As a form of debt, bonds are more secure than stocks in the event of a bankruptcy.

However, there are cases when a company is in such a bad financial situation that it cannot pay back its debts, causing them to default on its loans and bonds. Remember, the riskier bonds will often yield a higher return, but will also have a great fault of defaulting.

However, with the mass adoption of ECNs, most stocks can be bought and sold in a matter of seconds. Bonds, on the other hand, are extremely low in liquidity. The bondholder will not be paid back the principal of the investment until the bond reaches maturity, usually 10, 20, or even 30 years down the road. Interest Rate Risk Arguably the most direct threat to bonds is interest rate risk. If interest rates increase the day after the bond is purchased, the bondholder will be stuck getting unfavorable returns for the life of the bond.

It is recommended to purchase bonds of varying maturity lengths to help spread out interest rate risk. To learn more about the correlation between bonds and interest rates , check out this article by Investopedia. Prepayment Risk On the flip side of interest rate risk is prepayment risk.