Why Invest in Bonds?
Bonds are considered, alongside stocks and real estate, one of the three major investment categories that make up most family portfolios. Understanding the basics is very important.
How Are Bonds Issued?
Bonds can be issued by all types of companies, institutions, and governments. These include national governments (which issue what is known as “sovereign bonds” or in the United States means treasury bonds and savings bonds); state governments (which issue what are known as “municipal bonds”); corporations (which issue corporate bonds); and many more.
How Are Bonds Rated?
Bonds are rated by credit rating agencies. At the top of the ratings are investment-grade bonds known as AAA-rated bonds. At the bottom are high-risk bonds. Generally, the higher the rating, the lower the interest yields, as there is less risk deemed associated with holding the bonds. In other words, the perceived risk is higher than what will be repaid in principal and interest on time and in full.
Bond Risks
One of the main risks in your quest to earn money from bonds is inflation. The money you earn by the time the bonds mature, or its rate of growth, must be sufficient to combat inflation and protect your purchasing power. Some bonds, such as Series I savings bonds and TIPs, have some built-in inflation protection. However, investors do not always act more rationally. Not long ago in Europe, fixed-income investors were buying bonds for 50 and 100 years at historically low interest rates. Long-term bonds, along with low rates, meant they would almost completely lose their purchasing power by the time the bonds matured.
Investment Decisions
There are many factors to consider when trying to determine how much of your portfolio to allocate to bonds. Strategies will vary from one investor to another, so buying a bond may be smart for one person, while ill-advised for another. These choices can affect a variety of factors, from risk tolerance to invested assets to the market alternatives available at any given moment.
Capital Preservation
A large number of bond investors aim for what is known as “capital preservation,” since the money put into bonds tends to be capital that cannot be easily replenished, such as money earned from selling a family business after years or decades or generations of work. It might be wealth accrued from a very short but lucrative career (such as a professional athlete), or it might be inherited. This money may come from earnings over a professional lifetime, or at a time when the bond investor is too old to work again or in poor health and unable to reclaim the money if it is lost.
Advantages of Bonds
Bonds offer their holders many unique advantages. One such advantage is the ability to time cash flows precisely. By building bond ladders and buying bonds with specified dates for scheduled interest payments, you can help ensure that specific cash will be paid out at the exact time you need it. Some bonds also have unique tax aspects.
The benefits of investing in municipal bonds, for example, are enormous. Not only are you providing funding for building your local community (through schools, hospitals, sanitation, bridges, roads, social service programs, and other initiatives), but as long as you follow the rules and purchase the right type of bonds issued in your home state, you should be able to enjoy tax-free income as well.
Ensure
Pay attention to the placement of assets, which can affect your taxes in less obvious ways or negate other tax benefits of tax-advantaged accounts. For example, you should not hold tax-free municipal bonds through a Roth IRA.
Sources: European Central Bank. “Risks of Government Bonds in the EU: Impact of the Financial Crisis,” pages 11-12.
Source: https://www.thebalancemoney.com/introduction-to-fixed-income-securities-356072
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