Why Invest in Bonds?

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Why invest in bonds? We hear so much about stocks in the news but bonds don’t get mentioned with the same level importance and urgency (the Dow stock index gets all the glory on the 6 o’clock news).  Yet bonds are an integral piece of most portfolios as well as being an important debt instrument, used to create capital for businesses and municipalities.

While the stock market is a leading economic indicator, the bond market reveals what actually happens in the current economy. Bond prices rise and fall as interest rates change over time under different economic conditions.  The bond market is also a size of many times as the stock market.  Issuing bonds are much easier than launching IPO’s for a company (and government agencies can’t exactly launch an IPO).  Financing through various bond markets provide the necessary liquidity beyond any capital injection like by stock issuing.  In a modern economy, even the baking system must co-exist with the bond market.  For serious investors, the bond market holds certain real opportunities.

Here are some key reason to invest in bonds:

Principal Preservation

Despite the ongoing price change in any bond market, if a bond is held to maturity, investment principal is paid back by the issuer.  In a low rate environment, bond prices can keep rising and bond investors will also have the chance to participate in capital appreciation.  Low interest rates often persist when an economy is emerging from recovery and before it gets overheated.  In the event of a bond default and issuer bankruptcy, bond investors have preferential claims over equity investors.  Sometimes when a company’s common stock continues to perform poorly, in a capital restructure, bonds may be converted to preferred shares, which gives bond holders continued income payments as dividends.  Although the bond maturity is put on hold, note that certain preferred shares are not perpetual.

Predictable Income

While common dividends can be suspended and scraped, preferred dividends can be put in arrear, bond interest must be paid every six months in the form of coupon payments.  No dividends are excluded from personal income tax, but certain bonds are tax exempt with no tax paid on interest at either the state level or the federal level.  For investors with safety in mind, bond investing is a decent choice.  It offers a much higher yield than savings from banks but without raising risk considerably.  Bond investing is especially suitable for retirees and savers, such as of college funds.

Portfolio Balancing

Without bonds as part of a portfolio, investment losses from time to time could be in a much higher percentage if invested in stocks alone.  Although stocks can return well over the long run, in short or immediate term, they may well be outperformed by bonds, especially at certain times in the economic cycle.  Another layer of bond safety is through credit ratings.  While ratings on more exotic securities have failed, corporate bond rating has been fairly reliable.  No other investments provide such a systematic risk evaluation, be it real estate, stocks, or commodities.  Bond investors have an advantage when using bond rating as an investing guide to construct a balanced portfolio that stresses both safety and return.

Another important aspect of portfolio balancing is that bond prices tend to move opposite of stock prices in general.  Investing in bonds can help ease a period of dropping stock prices.

So you see, stocks get all the glory when it comes to investing but bonds are an important tool for many businesses as well as an important piece of a balanced investing portfolio.

What do you think of bond investing?  Why do you invest in bonds?

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Published or updated August 9, 2010.

Comments

  1. I’ve always been fascinated by bonds. They may seem dull and boring, but in times like these they can be quite interesting.

    I will say, though, it can be difficult to invest in bonds with most retail brokerage accounts — for example, the offerings from TradeKing and Schwab are pretty slim and you pay a pretty steep spread that erodes your yield. I suppose Schwab might argue they make up for the dearth of bonds with broad fixed income mutual funds…

    It can also be tricky to know exactly what you are buying via the trading interface of most retail brokerages: you won’t find any offering document or prospectus, and the name of the bond is frequently abbreviated in a way that obscures vital information about what the bond is financing and which cashflows support it.

    Hopefully, as more people allocate more of their portfolios to bonds, these interfaces will improve and retail brokerages will make more of an effort on the fixed income front.

    • Interesting info about the brokerages.

      For me, I stick with funds or ETF’s. You don’t get exact bonds but you do get to invest in them in an easier, broader way.

  2. I got “into bonds” when I was reviewing a client’s tax return and noticed she was receiving $250,000 tax free (granted she had multiple millions invested). I think muni bond investing is fascinating.

    Currently, I am focusing on SLOWLY building a dividend portfolio but muni bonds are next

    • Sounds like a good plan. Muni’s do seem interesting but they can have their risk as well. You still have to do your homework.

  3. Bonds just seem like a very unpopular investment choice these days. Personally, I think of them as something your gramma buys for you over the holidays, and you don’t really know what to do with it.
    The do seem like a good investment opportunity. How do their interest rates compare to CDs?

    • They could be unpopular since stock prices are relatively low these days and people would rather purchase stocks when prices are down.

      I was introduced to bonds as those things my grandma bought for me! The money grew and helped out a lot when I first moved out. Wish I still had them though.

      Bonds are a different beast than CD’s: different risks/rewards, commitments, ways to invest in them. I’d say CD’s are generally more liquid but will have lower rates but it really depends on what you are looking at.

  4. It’s very predictable but do you think you should invest in bonds opposed to something that is more liquid like just a money market account?

    • It depends on your time frame and your goals. There are many different kinds of bonds out there. If you want earnings with tax advantages then you can invest in muni’s or TIPS. For more liquidity you can invest in a bond mutual fund or an ETF (which trade like stocks).

      If you want more protection for your money and think you may need it soon, then a money market account is probably better.

  5. You can get an intermediate bond fund paying 7% which beats the return on any money market or savings account. You also get the liquidity aspect as well.

  6. I’m really afraid of bonds at current levels. I think it’s just one big BOND BUBBLE baby!

    Cash is king right now. I’m not investing much in either fixed income or equities.

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