Bonds make up the largest securities market in the world, and this is an area that provides extensive opportunities and options. There are some definitive advantages to investing in bonds. Some of the benefits of bonds include the fact that they have less volatility than stocks in most cases, but if you’re looking for significant returns, you’re better off going with a riskier investment strategy, because bonds tend to underperform most stocks over the long-term.
Bonds are often favored by older investors and people who are nearing retirement because they allow them to preserve capital and earn regular income, but for younger investors, they might go another route to earn more capital.
Along with these factors, the following are some important things to know about investing in bonds.
What Is a Bond?
A bond is a loan made by the holder to the issuer. Usually, bonds are issued by governmental organizations, corporations, and municipalities to get capital when they need it. If you’re an investor buying a government-issued bond, you’re essentially providing a loan to the government, and the same goes for buying a corporate bond.
You earn money because as with any loan, the borrower is paying interest as they repay the loan. The principal has to be repaid by a certain time, which is known as its maturity date.
The Role of Interest Rates
Interest rates play a significant role in the bond market. Recently there has been a lot of attention placed on the Federal Reserve, in particular, because of their likelihood to raise interest rates in the coming year, possibly several times.
Investors should realize that this can impact their bonds. The price of bonds tend to go up when interest rates fall, and the prices go down with rates go up. There’s an inverse relationship, so a portfolio made up of primarily bonds could be impacted by rising interest rates.
One of the most popular types of bonds to invest in are municipal bonds. Municipal bonds are issued by state and local governments, and these loans are usually obtained by these governmental bodies to finance construction projects and deliver services.
One of the primary benefits of municipal bonds is that they have higher interest rates than U.S. treasuries, and they also have a pretty low level of risk associated with them.
Another advantage of municipal bonds are the tax benefits they carry. These bonds are exempt from federal income tax, and if you’re a resident of the issuing state, also state and local taxes.
Despite the many advantages of municipal bonds, there is a risk that comes with the potential for local governments to default on their loans if they see a decline in tax revenue.
Another factor that can impact the price of bonds is the credit quality it carries. Credit ratings are assigned to the borrower of the bond, and they range from AAA to C. If there is a higher likelihood that an issuer is going to default, they’ll receive a lower rating.
Investing in bonds can be part of a larger portfolio strategy to balance risk, although it’s not necessarily the best option for younger investors who want to grow their wealth, and is more advisable for older investors who are getting close to retirement or who are in retirement.