Pros and Cons of Bond Investing
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The mechanism of bond investing is simple. To buy a bond is to loan your money to the government or a corporation. Once your bond matures, the bond issuer will pay back the principal plus interest. Sounds like a carefree way to invest, doesn't it? Who wouldn't like a steady stream of income? No sweat. No fret. No stock-market frenzy. It is a popular mode of investment among retirees as well as younger peeps who plan to pursue their financial dream slowly and safely. Bond investing surely offers many plus points, yet like many other investments, it also poses certain disadvantages. Putting your money in bonds isn't absolutely risk-free as many unseasoned investors assume. To stay on top of your financial game, be sure to familiarize yourself with both the pros and cons of bond investing.
Pros and Cons of Bond Investing
Shallow Learning Curve
Advantages of Bond Investing
With bond investing, you literally make money while sleeping. All you have to do after purchasing a bond is wait patiently and watch your money grow. Let some people lose nights of sleep and their sanity over the stock market's volatility. Your bonds may not ignite much excitement but they certainly grant you peace of mind.
Shallow Learning Curve
Bond investing is almost as simple as having a savings account. You do have to choose the right bonds to suit your personal financial goals and sometimes take certain risks, yet it's still a lot easier compared to picking stocks. Predicting stock returns is an awfully complex task. Even those who are so well-versed in reading stock prospectuses still can't beat the market. To gain a momentous success in stock investing, you need to be a trained analyst or hire a trustworthy expert to manage your investing portfolio. Bonds, on the other hand, are something you can handle on your own even if you don't have an extensive background in business and finance.
When you buy a bond, you know exactly how much money you will get back at the end (unless you want to sell it before maturity). Bond issuers pay interest regularly, and the returns are fixed. A bond's face value or price at purchase is called the "par value," whereas its interest payment is known as the "coupon."
Certain bonds are tax-exempt, but most investors are not thrilled by them because these tax-frees usually pay lower yields. If you are among those in high tax bracket (28% or higher), however, tax-free bonds are excellent options to consider. They can actually earn you more money than taxable bonds.
Bond Investing Risks
This risk doesn't refer to your personal credit scores but your bond issuer's financial health. The assumption that bonds are completely risk-free is inaccurate. Yes, bonds issued by the U.S. Treasury contain virtually no risk. The only chance to lose your money on a government bond is if, God forbid, the government defaults on its loans. But of course, that is extremely improbable. Not all bond issuers are as reliable as Uncle Sam, however. Some of them may not be able to make their payments on time or at all. To stay ahead of the game, you can check bond issuers' credit worthiness through bond rating agencies, such as Standard & Poor's (S&P) and Moody's.
During inflation, prices of goods and services rise while the purchase power of money plunges. Since bond interest payments are fixed, the value of your bond will also be inevitably eroded by inflation. The longer the bond's duration, the higher the inflation risk. Most financial experts would agree that stocks are more inflation-resistant. Nevertheless, inflation-protected bonds also exist. These bonds pay "real rates" of interest, adjusted by the Consumer Price Index. Keep in mind, though, that you can't collect the inflation adjustment until your bond matures but still have to pay yearly federal income tax on that "phantom interest", in addition to the tax on the interest you receive currently.
By investing in bonds, you won't see your money for a few years. You know it is there but just can't get your hands on it. Selling your bonds before maturity is an option, but the market is often illiquid. Chances are you might have to sell them at a rate lower than your purchase price. Cashing in your bonds early is also doable but you will be severely penalized. For most bonds, a typical penalty for premature withdrawal is a substantial deduction of interest payments.
Those who aggressively invest in stocks could either become a millionaire before they know it or lose their entire fortune overnight. Bond investors, on the contrary, usually don't expect to experience either of those. Some may argue that stocks don't always outperform bonds. Yes, if you look at the long history of the bond and stock markets, it's evident that they have taken turns outpacing each other. On average, however, the return on a high-yielding bond tends to be significantly less than the return on a well-performing stock.
Bond Investing - Five Things to Remember
Bond Investing Basics
1. Invest in long-term bonds if you're seeking large payouts.
2. If you want a low-risk and steady income, short-term bonds are your best bets.
3. U.S. treasuries may not always offer attractive yields but they are the safest bonds to invest in.
4. Unless you're buying U.S. treasury bonds, always check the bond ratings first.
5. For serious investors, don't put all your money in bonds. It's better to also buy some stocks and diversify your portfolio.