Investing in bonds has been very popular in recent decades. The financial industry has promoted them actively. We analyze what bonds are, reasons for investing in them, and the main risks to consider.
- The Bond or Fixed Income Market
- Example Bond
- Reasons for Investing in Bonds
- Risks of Investing in Bonds
The Bond or Fixed Income Market
Bonds are part of the fixed income market. In fact, the bond market is the largest segment of the fixed income market. The term “fixed income” is used to indicate that most of their future cash flows are indeed fixed. We could also refer to the bond market as debt market.
Bonds are debt instruments issued by all sorts of governments and corporations. Because some governments and companies borrow a lot of money, it is not feasible for them to borrow that money from a bank.
For this reason, they decide to issue bonds to investors interested in lending money. In return, these governments and companies agree to pay a certain amount of interest and return the money on a pre-agreed date.
Once in the hands of investors, bonds can be actively traded. Bond prices change constantly and sometimes dramatically. There are many factors influencing bond prices: movements in interest rates, credit spreads, inflation, economic growth, political risks, etc.
There are many different types of bonds. Indeed, we are talking about a very heterogenous market. Some bonds are safer than having money in the bank, while some others are riskier than investing in stocks.
In the next few sections, we will discuss the main reasons for investing in bonds, as well as the biggest risks it carries. We will sometimes mention a theoretical bond. If you want to read a detailed explanation about the most important characteristics of a bond, visit this link:
How to Analyze Bonds – Most Important Characteristics
We will use the following theoretical bond as an example:
- Issuer: US Government (Treasuries)
- Coupon or Interest Rate: 4% paid semi-annually, or 2% every 6 months
- Issue Date: 31 October 2008
- Maturity Date: 31 October 2038 (30 years later)
- Notional Amount: $100,000
- Price Paid: $100,000 (equivalent to having paid 100 of par)
Therefore, we paid $100,000 for this bond in 2008. Every six months for the next 30 years, we will receive $2,000 in interest. After those 30 years, the bond will mature, and the US government will pay us $100,000.
It is easy to compute the annual return of such an investment. If all goes well, there is no default, and we hold this bond until maturity, our realized return will 4% per year.
At any given time, though, our return can be different. This is because bond prices fluctuate constantly, and we have the option to buy and sell bonds whenever we want to.
Reasons for Investing in Bonds
Let us now discuss the main reasons for investing in Bonds:
The main reason for investing in bonds is diversification. Investing in bonds allows us to diversify our portfolio and reduce the risk of our investments.
So that you can understand how diversification works, let us discuss the following two potential investments:
- 6% guaranteed return annually, without any risk of loss
- 8% average expected return annually, with the potential to go much higher but also realize large losses, including drawdowns of over 50% at times
Which investment would you choose? It depends on your circumstances and risk appetite. In general, the higher the return and the lower the risk, the better. So, the decision boils down to, again, our circumstances and appetite for risk.
However, financial markets do not make us choose between two investments. We have the option to combine many different asset classes. The goal is to reduce the overall risk of our portfolio, while still maintaining an attractive expected return.
Adding bonds to your investment portfolio will help you reduce risk by boosting diversification.
2) Safe Haven Asset
Apart from having the potential to generate moderate, yet steady returns, bonds can also act like a safe haven, particularly government bonds. This is especially true in times of economic and financial stress.
When the economy falls into recession, interest rates are usually cut in order to stimulate the economy. Lower interest rates lead to an increase in bond prices. Owning bonds in our portfolio will cushion the losses experienced by other asset classes due to the recession.
Owning bonds in times of financial hardship can not only cushion our stock losses, but also make it possible for us to have dry powder available to acquire good quality assets when they go on sale.
3) Steady Cash Flows
This is another important reason for many investors to invest in bonds. Similar to dividend-paying stocks, most bonds also pay interest. The difference is that bonds’ interest payments are usually safer than dividends.
Therefore, for those investors interested in generating cash flow, perhaps because that supports their lifestyle, investing in bonds is a great option.
4) Risk of Deflation and Economic Stagnation
The value of stocks in a given country is driven by two main variables: the size of the real economy and the general price level. The higher the economic growth, the more valuable the stocks, and the higher the dividends. To some extent, the same applies to moderate inflation rates.
However, in times of low economic growth and low inflation, stocks often perform poorly. However, this scenario is ideal for bonds. This is because interest rates will be cut, pushing up bond prices.
Risks of Investing in Bonds
As you can imagine, many of the reasons for investing in bonds can also be interpreted as risks. And, in that case, stocks would outperform bonds. For example, a scenario of strong inflation and rising interest rates will likely lead to large losses in our bond investments.
Additionally, a recession can lead to losses if we have invested in corporate bonds and many companies have to declare bankruptcy.
Nevertheless, since predicting the future is not possible, it is worth considering investing a portion of your portfolio in bonds.
As you can see, holding bonds in your investment portfolio can make it more robust. Combined with stocks, gold and other asset classes, they form a very powerful combination. If you are young and investing for the long-term, you do not need a large position in bonds, but it is still something to consider.
Investing in bonds is easy. There are many different types of exchange-traded funds that make it possible to invest in the bond market.
If you would like to learn more about bonds, check out this section:
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