By Michael Feng. Edited by Arjun Chandrasekar.
What are Bonds?
In order to mitigate risk and protect their portfolio, many investors diversify their portfolio by investing in not only numerous sectors, but also a variety of different investments including stocks, bonds, derivatives, and other options. Today we’re going to be discussing an option that introduces significantly less risk into a portfolio: bonds. Bonds come in numerous forms, but in almost all cases, bonds are a type of loan that is given out to investors which promises returns in the form of interest, guaranteed returns at maturity, or compensation with stock.
Who Issues Bonds, and Why?
Because bonds can be thought of as loans, two important aspects of bonds are necessary to be examined: the buyers and issuers of bonds. First off, we’ll talk about who issues bonds and why they might issue bonds instead of taking a loan through another method.
According to Investopedia, common issuers of bonds include: “companies, municipalities, states, and sovereign governments to finance projects and operations.” Governments may need to fund materials necessary for war, new educational systems, or industrial projects. Companies may need to issue debts in order to invest more into research and development (R&D) or expand their market share into new industries or sectors.
Governments or companies may choose to issue bonds because they have no other option. To explain, banks often provide loans for common citizens for purposes like mortgages, which may seem like a lot of money, but is only a tiny drop into their total balances. However, once the question of billions of dollars comes into play, banks either may not be willing to loan out that much money or simply cannot afford to. Thus, instead of a single entity acting as the lender for this loan, individual investors may choose to provide a small percentage of the total quantity a company or government needs and receive some sort of ROI in return for loaning money to these corporations.
What Can Investors Expect?
Of course, bonds are only one form of investment, so let’s analyze the returns investors may expect from bonds. Returns promised to buyers often come in the form of interest paid continuously over time, but can also come in many other forms. While normal bonds pay out interest over time and return you your initial investment at maturity, there are plenty of other options for issuers and buyers to choose from.
Among those, the one that is most important to understand is Zero-Coupon Bonds. Zero-Coupon Bonds don’t pay interest over time; instead, these bonds offer a specified amount of money at maturity. Government bonds are Zero-Coupon Bonds. To further illustrate what Zero-Coupon Bonds are, hypothetically, if you were to invest $10,000 in a 10-year government bond, the government may offer to return you $11,000 at the end of 10 years instead of $100 a year and $10,000 at maturity.
Pros and Cons of Bonds
While diversification is always encouraged, considering your options on what ways to invest is necessary when constructing your portfolio. For example, those with a high-risk portfolio and a long time horizon may not need bonds when other investments will provide a better return over the long term. Thus, discussing the pros and cons of investing in bonds will be a good guide to analyze when choosing what investments you want.
The most noticeable and obvious benefit of bonds is their stability. While stocks may lose money over time, bonds like those from governments have a much lower chance to default since they can always increase taxes to recoup costs. In addition, similar to dividends, income from interest may be a good way to gain passive income. Furthermore, most corporate bonds can be traded, so if the value of your bond increases, you can sell it for a profit without waiting until maturity, with pretty high liquidity as well.
However, investments with less risk will generally come with lower rewards as well. In exchange for their stability, bonds offer significantly less returns than stocks. As a general rule of thumb, the older you get, the more bonds you should own as you have less time for your riskier investments to recoup any potential losses they may have by the time you retire. In addition, sometimes the interest payments on bonds can decrease due to fluctuating interest rates. Last but not least, corporations can default on bonds, making you lose a significant amount or all of your initial investment, something that happened in the 2008 financial crash.
For those of you still young, bonds are generally something unnecessary to worry about, unless you’re investing for short-term wealth preservation and gaining a small return, since, with a risk appetite, lower-risk investments are generally not worth it, offering lower returns (not financial advice). However, understanding how your needs change over time and consequently your portfolio as well, understanding what bonds are are still vital to financial success!