Investing in bonds can be a wise financial decision, but is it always a good investment? Bonds have long been considered a safe and stable investment option, offering a fixed income stream and lower risk compared to other investment vehicles. However, the investment landscape is constantly changing, and it's crucial to stay informed about the current market conditions and factors that may impact the performance of bonds.
Before jumping into the bond market, it's essential to understand the potential pitfalls and drawbacks associated with this investment. While bonds can provide stability and income, there are certain factors to consider that may affect their profitability.
In this article, Benzinga explores the advantages and disadvantages of investing in bonds, helping you make an informed decision about whether they are a good investment for you.
What Exactly Are Bonds?
Bonds are debt securities that are issued by governments, municipalities, and corporations to raise capital. When you invest in bonds, you essentially lend money to these entities in exchange for regular interest payments and the return of the principal amount at maturity.
Why Invest in Bonds?
Bonds can be an important part of your investment profile, especially when it comes to the long term. Bonds offer predictable financial benefits without complicated strategies, and casual and non-investors can leverage this type of security just as easily as active traders.
Bonds are especially popular if you’re looking to save money for a long-term goal. For example, you might buy bonds when you’re in your 20s or 30s to provide a little extra cushion at retirement. You might also buy them to give to your children to cash out when it’s time to pay for college or buy a house in adulthood.
3 Reasons Bonds Are a Good Investment
In terms of trading, there are benefits bonds can offer that other long-term investments can’t. Here are three reasons bonds can be a good investment.
Bonds Provide Fixed Income
Bonds are another way to grow your money, providing a reliable income stream. Bonds are less volatile than stock market investments.
With the bond markets, even when interest rates are low, there are still options to make sure you’re hitting your income targets.
Bonds Allow You to Diversify Your Portfolio
Diversifying your portfolio means you’re making sure you’re not putting all of your eggs in one basket. By investing in a variety of products, you lower your risk of losing out on a return.
For example, if you’re already trading on the stock market, it wouldn’t hurt to consider adding bonds to your investment strategy. When the stock market isn’t doing well, you can lean on your bonds to preserve your capital until the stock market has an upswing.
Bonds Provide Tax Benefits
Bonds offer tax benefits. If you trade bonds from U.S. Treasuries, you can rest easy knowing that this income is tax-free on state and local levels.
Municipal bonds are tax-free at the federal level. And if you buy a municipal bond issued by the state you live in, you won’t need to pay state tax on it either.
Types of Bonds to Invest In
Think of bonds like a bank loan, but you’re the bank that benefits from the interest charged. The difference in types of bonds lies in which entity issues the bond and how the funds are used. Here are four main types of bonds.
1. Treasury Bonds
Treasury bonds or Treasury bills are known as the highest-quality securities you can get. They are issued by the U.S. Department of the Treasury and have a maturity date that can range from 10 to 30 years.
When your government bond reaches maturity, the principal and interest will be repaid. It will also stop earning interest payments.
You won’t need to pay state or local taxes on the interest earned by these government bonds. Since they’re backed by the government, there is little credit risk or risk of default.
2. Sovereign Bonds
Sovereign bonds are also issued by the federal government and can be denominated in the U.S. dollar or in a global reserve currency. The government uses sovereign bonds to fund government spending programs. There are different types of sovereign bonds, such as agency bonds and savings bonds.
3. Municipal Bonds
Municipal bonds are also issued by state and local governments. They’re used to fund the construction of public projects like schools, housing, highways and sewer systems.
Different types of municipal bonds exist — general obligations bonds and revenue bonds. If you trade municipal bonds, note they are exempt from federal income tax. Your bond may be exempt from state and local taxes as well if you live in the issuing state.
In some cases, your bond may be subject to federal, state and local alternative minimum tax. Although these bonds are issued by the government, municipal bonds pose a higher risk because local governments are more likely to go bankrupt than the federal government.
4. Corporate Bonds
Corporate bonds are issued by corporations to fund business expansions and large capital investments. Overall, this is a less predictable type of bond because the risk depends on the financial outlook and reputation of the company.
But corporate bonds can also provide higher rewards for your investment. Another corporate option is convertible bonds — corporate bonds that can become company stock.
Should You Invest in Bonds When You Are Young?
It’s a myth that you can’t start investing when you have student debt on your back. If you’re a young investor, you have time on your side, and you can reinvest what you earn to generate wealth over time. Young investors also have the time to assume more risk. Once you’re close to retirement age, you should decrease your risk in favor of earning potential and security.
Investing in bonds provides a low-risk way to dip your toes in the water. A buy-and-hold strategy allows you to buy a bond and hold onto it until it matures. By doing this, the only way you or a bondholder can lose money is if the issuing entity goes bankrupt and can’t repay.
Best Brokerages for Bond Trading
When it comes to trading bonds, you’ll want to look for a brokerage. A broker can offer you the tools and resources to help compare and find the best bonds for your portfolio.
Some online brokers will give bondholders access to a fixed-income specialist to review their portfolios and make suggestions.
Here are some of the best brokerages for bond trading:
Why You Should Invest in Bonds
If you’re ready to become a bondholder and want a predictable income stream, you should likely invest in bonds. No matter your age, bonds can provide security when the stock market is failing, offer additional tax benefits and diversify your portfolio.
Whether you’re risk-averse or ready to dive in and take chances with your investments, know there really is a bond investment strategy for everyone — including you.
Stability and Growth
Investing in bonds can provide predictable financial benefits and serve as a reliable source of fixed income. It offers portfolio diversification and tax benefits, and bonds are suitable for investors of all ages. With various types of bonds available, there are options to suit different risk appetites and preferences. Bonds offer stability and potential growth to safeguard one's financial future.
Frequently Asked Questions
Should I increase my investment in bonds as I age?
Stocks can offer a better return, but bonds are generally considered a safer investment. Some advisers recommend increasing the percentage of your portfolio committed to bonds as you age. And some bonds bring potential tax breaks.
Speak to your financial adviser to create an investment strategy.
Does it matter how long I hold on to a bond?
Yes. Bonds are sold for a fixed term from 1 to 30 years. You can sell a bond before it matures, but you run the risk of reducing your expected return.
Some people buy into a bond fund that pools a variety of bonds. This is a good way to diversify, but these funds are more volatile.
A bond’s interest rate is fixed at the time of purchase, and interest is paid regularly for the life of the bond. The full original investment is paid back when the bond matures.
Can I sell my bonds before they mature?
Yes, bonds can be sold prior to their maturity, but the price may be influenced by market conditions, changes in interest rates, and the issuer’s credit rating. Selling bonds before maturity may result in capital gains or losses.