In 2020 the global bond market reached an outstanding value of $128.3 trillion. There are many assets that people can invest in, and bonds are one of the most popular choices. They provide a way for you to use your money to generate more income, but they do come with some potential disadvantages. For a rundown of what bonds are, how to invest, and the pros and cons of bonds, keep reading.
What Are Bonds?
Bonds are a financial asset, but rather than having ownership, they represent a loan from you to the bond issuer. When you buy one, you’re loaning money to the government or another institution. They’ll then pay you interest for a fixed period.
The money you’ve loaned out is known as the face value, or principal, and the interest payments you receive are known as coupons. At the end of the agreed period, the institution will pay you back the principal in full.
Investing in Bonds
The main reason people invest in bonds is to make profits, and there are two ways you can do this. The first method is to buy a bond and hold it while collecting interest payments. Once the agreed period is up and you receive the principal back, your total profits will be equal to all the interest you were paid.
For example, if you buy a 10-year bond for $10,000 with 3% interest, you’ll be paid 3% each year through 2 instalments (every 6 months). This interest compounds, so while the first year would be $300, the second would be slightly higher, and so on. After 10 years, you get the initial $10,000 back.
The second method of investing is to buy a bond and then sell it for a higher price than you paid. This is dependent on the market value. If you were to buy the same bond as above, for example, and then sell it once the market value increases, you could make a profit on it.
The value of a bond can rise if the institution’s credit risk profile improves. This is because it means they’ll have a better chance of repaying the bond at maturity. The value can also go up if the prevailing interest rates go down.
Types of Bonds
Before you do any bond investing, you should know about the different types available. Each type has different advantages and disadvantages.
These are issues by companies rather than governments. This means they have a higher chance of defaulting, but they also generally pay more interest.
Also known as “muni bonds”, these are issued by local government entities like states and cities. The purpose of these is to fund public projects or services such as parks or bridges.
These are also called T-bonds and are issued by the US Government. These tend to offer quite low-interest rates, but also have very little risk of defaulting.
The Pros and Cons of Bonds
Other than bonds there are various types of assets you can invest in. When thinking about investing in bonds you should weigh up the different advantages and disadvantages associated with them.
One of the main advantages of bonds is that they provide safety as an investment. The income is generally more predictable than other investment opportunities, meaning you have a better idea of the kind of profits you’ll make. They are also less volatile than other assets, so it’s unlikely the value of a bond will suddenly drop.
The income from bonds is not just predictable in terms of the amount you’ll make, but also its regularity. Interest payments are paid twice a year so you can handle your finances accordingly. If you decide to sell for a profit, you can do this whenever you choose.
If you purchase a muni bond, the money you invest will be going towards something to help your local community. This could be a school, hospital, public garden, or more.
If you’re already an investor, you probably know that it’s good to have a diverse portfolio. Having a mix of stocks, bonds, and other assets can reduce your financial risk and increase your potential to make profits.
While they are one of the more secure investment options available, there are some potential downsides to investing in bonds. One of the most obvious is that the money you invest will be locked away for long periods, and you won’t be able to access it without selling your bonds.
When buying bonds you’re making a long-term commitment, and the issuer may change their interest rates while you’re still holding. If you invest at an interest rate of 3%, then the issuer increases their rate to 4%, and the value of your bond will go down. You won’t be able to take advantage of the new interest rate unless you invest again.
One of the main risks of bonds is the possibility of the issuer defaulting. This is uncommon, but if it does happen you could lose your principal, your interest payments, or even both.
Compared to the stock market, the bond market is lacking in transparency. This means that brokers may sometimes charge higher prices than they should. It can be harder to determine if the price of a bond is accurate for its value, so you might end up overpaying.
Bonds remain one of the safest investments, but along with this, it means that you’ll usually get smaller returns. When it comes to investing it’s often the case that higher risk means a higher reward.
Should You Invest in Bonds?
Before investing it’s important to weigh up the pros and cons of bonds. They’re generally secure and reliable, and can even help out your local community. Just remember that you may not make the best returns, and there’s always a possibility of losing your investment.
If you want to start investing, it’s crucial that you know the market and understands what you’re doing. At CFI.co we provide updates and information on all things finance, business, and economics. Click here to sign up for our newsletter or contact us with any questions today.