One of the key considerations while choosing an investment option these days is the return it will yield and the risk associated with it. A balanced investment portfolio must be spread over diverse options, including bonds. We understand that the concept of bonds and their working might be a bit overwhelming for new investors so we have compiled a short guide to understanding bonds. This is as simple as it gets guys, so gear up!
Simply put, a bond is a fixed-income instrument, one of the three main asset classes. It is a loan from an investor to a borrower. This may include companies and governments alike. This way of investing renders the need to actually buy a stake like stocks unnecessary and focuses primarily on lending the money. The borrower then uses the investor’s loan to carry out their operations. In return, the investor receives interest on the investment. The market value of the bond is also liable to change over time. It is pertinent to include bonds in investment portfolios because they help balance out an investor’s risk over time. In the worst case scenario that the stock markets crash, then investors who have also invested in bonds, can avoid the brunt of the plummeting stocks. The fundamental benefit that investing in stocks has over other investment options is their lower volatility and the comparative safety that they offer in contrast to stocks.
The yield of a bond is the anticipated earnings made on a fixed-income investment over a specific period of time, which are denoted as a percentage which is the interest rate. There are more than one ways to calculate the bond’s yield and these in turn can be associated with the bond’s potential risk and return. Therefore we cannot stress enough on the importance of understanding which type of yield is expected when performing due diligence prior to finalizing which bond to invest in. It is also important to remember the risk vs. return ratio when analyzing the yield. Naturally greater security comes with lesser returns and the higher the risk, the greater the expected return. Therefore setting a target for the yield you wish to earn in returns depends largely on your risk/return profile as an investor and also additionally on the prevalent interest rates and the issuer’s creditworthiness.
It is important to note that each category of bonds comes with its specific set of pros and cons that must be studied in detail. For example, corporate bonds are issued by companies when they feel they need to raise money to fund their ventures and projects and unlike buying stocks, the purchase of corporate bonds does not give others the ownership claim over the corporation issuing them. In contrast Municipal bonds are used to fund state or city projects, like building infrastructure such as highways and schools. These may come with the added advantage of tax benefits, with bondholders being exempted from paying federal taxes on the interest as well as exemption from the state and local taxes if they’re issued in the same state/city.
Do keep in mind that despite them being projected as low risk, in reality there are some risks associated with bonds even if they are one of the most popular investment choices. There is a high chance that you will have difficulty selling a bond if the interest rates go up. Similarly inflation results in reduced purchasing power as time lapses and the fixed income earned on bonds might actually lose value over time. In worst case scenarios the bond issuer may be unable to timely pay the investor the interest that they owe them leading to Default risk. Therefore, we urge you to read up about the pros, cons and associated risk and returns with each type of bond before you reach a conclusive decision regarding your investment, but a diverse portfolio definitely has added advantages for you as an investor!